Explain the Fisherian hypothesis and the Fisher equation of the relationship between interest rates and inflation.

Explain the Fisherian hypothesis and the Fisher equation of the relationship between interest rates and inflation. 

Ans. Fisher’s hypothesis claimed that real interest rate is not a function of monetary measures. Fisher equation can be written as follows: r n = r r +  e where, r n is nominal rate of interest; r r is real rate of interest  e is expected rate of inflation. Hence, in order to keep the borrower at no profit, no loss level, if expected rate of inflation is increasing, then real rate of interest must also rise. It is called fisher effect. It is based on the concept of neutrality of money. According to the principle of neutrality of money, an increase in the rate of money growth increases the rate of inflation but it has no real effect. Nominal interest rate is simply what you are getting on your savings in a bank account or on any loan that you have given to someone. The value of your principal is decreasing over time due to inflation. When interest that you are receiving is adjusted for this fall in purchasing power, we get real rate of interest. Therefore, I r = I n –  e Where, I r =Real interest rate; I r = nominal rate of interest  e = Expected rate of inflation. Fisher hypothesis claims that in the long run, purely monetary developments will have no effect a country’s relative prices because if inflation permanently rises from a constant level, to a constant level, that currency’s interest rate will eventually catch up with the higher inflation and real return on that currency will remain unchanged.