Irving Fisher: Biography & Theory of Interest

Instructor: Shawn Grimsley
Irving Fisher was as an American economist who made important contributions in economics. In this lesson, you'll learn a bit about Irving Fisher and his theory of interest. You'll also have a chance to take a short quiz.

Irving Fisher

Irving Fisher (1867-1947) was born in Saugerties, New York, in 1867. Fisher received a doctorate at Yale in 1891 in economics and mathematics. He taught mathematics at Yale from 1895 until he joined the political economy faculty (an older term for economics). In 1935, he became professor emeritus.

Fisher made important contributions to the fields of statistics, econometrics and index number theory. A significant amount of his work contributed to the development of modern monetary theory. He developed the modern quantity-theory-of-money equation and developed a theory regarding interest rates and inflation in his work entitled The Theory of Interest (1930), which we will discuss in a while. Some of his other important books include Purchasing Power (1911), The Nature of Capital and Income (1906), The Making of Index Numbers (1922), and Booms and Depressions (1932).

Fisher was also actively involved in business and was a political activist. He made a fortune marketing a card-index file system he developed. Politically, he supported reform causes related to health, conservation, and prohibition. He was also a supporter of the League of Nations.

Theory of Interest: The Fisher Effect

One of Fisher's greatest contributions to the field of economics was explaining the relationship between inflation and the real and nominal interest rates. This relationship is known as the Fisher Effect.

Before describing the Fisher Effect, it's important to understand some key terms. Inflation is a rise in the general price level of an economy. The real interest rate is the rate of interest adjusted for inflation, while the nominal interest rate is the rate of interest that is not adjusted for inflation (it's basically the rate reported on loan statements and investment statements). You can determine the nominal interest rate by taking the real interest rate and adding the inflation rate to it, and you can calculate the real interest rate by subtracting the inflation rate from the nominal interest rate. Now, on to the Fisher Effect.

The Fisher Effect states that an increase in the growth rate of the money supply will result in an increase in inflation and an increase in the nominal interest rate, which will match the increase in the inflation rate.

This Fisher Effect helps explain why we should not see inflation affecting the real interest rate in the long run. In order for real interest rates not to be affected by inflation, the nominal interest rate must mimic the changes in the inflation rate. If inflation increases by 2%, nominal interest rates must increase by 2%. This keeps the real interest rate unchanged because the increase in the nominal rate and the increase in the inflation rate cancel out any effect on the real interest rate.

Example

If the real interest rate is 5% and the inflation rate is 3%, the nominal interest rate is 8% because the nominal interest rate equals the real interest rate plus the inflation rate (that is, 5 + 3 = 8). Now if inflation rises by an additional 1% because of an increase in rate of growth in the money supply, the Fisher effect says that the nominal interest rate will rise by 1% as well. What happens to the real interest rate? Let's do the math.

Real Interest Rate = Nominal Rate - Inflation Rate

Real Interest Rate = (8 (the rate before inflation) + 1 (increase in the nominal rate)) - (3 (prior inflation rate) +1 (increase in inflation))

Now let's remove the annotations for clarity:

Real Interest Rate = (8 + 1) - (3 + 1)

Real Interest Rate = 9 - 4

Real Interest Rate = 5% - the same it was before the inflation and rise in nominal interest rate.

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