Example

This real rate is the same as we had before. If we take another look at the Fisher effect, we can rearrange things a little as follows:

What this tells us is that the nominal rate has three components. First, there is the real rate on the investment, r. Next, there is the compensation for the decrease in the value of the money originally invested because of inflation, h. The third component represents compensation for the fact that the dollars earned on the investment are also worth less because of the inflation.

This third component is usually small, so it is often dropped. The nominal rate is then approximately equal to the real rate plus the inflation rate:

The Fisher Effect

If investors require a 10 percent real rate of return, and the inflation rate is 8 percent, what must be the approximate nominal rate? The exact nominal rate?

First of all, the nominal rate is approximately equal to the sum of the real rate and the inflation rate: 10% + 8% = 18%. From the Fisher effect, we have:

Therefore, the nominal rate will actually be closer to 19 percent.

It is important to note that financial rates, such as interest rates, discount rates, and rates of return, are almost always quoted in nominal terms. To remind you of this, we will henceforth use the symbol R instead of r in most of our discussions about such rates.

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