The Fisher Effect and the Quantity Theory of Money

Eric Mahaney

4/7/13

EC-301-1

The Fisher effect and the Fisher equation were made famous by economist Irving Fisher. He created his equation by rearranging the equation for real interest rate, which is (r = i - π). Real interest rate equals the nominal interest rate plus inflation. This is a very basic equation. Fisher manipulated it to solve for i, in order to understand the effect that inflation has on nominal interest rate. The famous equation is i = r + π, nominal interest rate equals real interest rate plus inflation. This is basically saying that the nominal interest rate can be changed by a change in either the real interest rate or inflation. The Fisher effect is the …show more content…

(WorldBank) From the graph above it seems that there is somewhat of a lag between the change in money supply and the subsequent change in inflation. For example, between 1969 and 1971 the United money supply drastically increases. However, it is not until 1973 and 1974 that the U.S. experiences high inflation. Many economic scholars estimate an approximate two year lag in the time that monetary policy is enacted, which holds in this graph. In the mid-eighties there is sharp drop in the inflation rate. After 1983 the money growth still seems to have a positive relationship with inflation, however there is much less volatility in the inflation rate. The money growth rate fluctuates between zero and twelve percent. Inflation, however, stays fairly steady between two and five percent. In 1981, in order to deal with the high inflation in the 1970’s, Paul Volcker, the Chairman of the Federal Reserve Board, contracted the money supply. This drastically lowered the inflation rate and then Volcker flooded the economy with money. This explains the low inflation in 1983. From 1995 through 1999 there is little correlation between the two variables. The money growth rate increases drastically while the inflation rate remains steady. This deviance from the theory can possibly be attributed to the declines in import prices and declines in labor’s share in