Fisher effect

The Theory of Interest (Fisher, 1930) is grounded in neoclassical economic thought. According to Fisher (ibid., p. 495), the interest rate is determined by three conditions: (i) market equilibrium; (ii) "at the margin of choice", the equalization of the rate of time preference with the market interest rate; and (iii) the equalization of the "rate of return over the cost" with the market interest rate. The equilibrium interest rate is therefore determined by real (non-monetary) variables: the rate of time preference that determines savings (an upward-sloping function), and the marginal return on investment that deter- mines the demand for loans (a downward-sloping function).

Fisher (ibid.) argued that, in the absence of inflation (that is, a situation with a "stable purchasing power of money" in Fisher's own words), the nominal rate of interest and the real rate of interest would be the same according to his theory, while changes in the purchasing power of money would involve a discrepancy between these two rates. This is because inflation, provided that it is foreseen, increases the return on investment, thereby increasing the number of transactions and pushing investors to increase the demand for loans until the nominal interest-rate increase equals the rate of change in the price of transactions.

Fisher (ibid., pp. 493-4) insisted that this "perfect theoretical adjustment" is an approximation of what happens in the real world, where "the appreciation or deprecia- tion of the monetary standard does produce a real effect on the rate of interest [. . .]. This effect is due to the fact that the money rate of interest, while it does change somewhat according to the theory [. . .] does not usually change enough to fully compensate for the appreciation or depreciation". However, Fisher considered that the imperfect adjust- ment of the money rate of interest was a short-run phenomenon, owing to some lag in the real-world adjustment process ("money illusion" was assumed to play a crucial role in this respect). In the long run, changes in the purchasing power of money should lead to a proportional change in the money rate of interest, without a substantial effect on the real rate of interest: "the results and other evidence, indicate that, over long periods at least, interest rates follow price movements. [. . .] Our investigations thus corroborate convincingly the theory that a direct relation exists between P¢ [the change in price] and i, the price changes usually preceding and determining like changes in interest rates" (ibid., p. 425).

The Theory of Interest was actually presented under three "approximations" of increas- ing complexity: (i) assuming that each person's "income stream [is] foreknown and unchangeable" (except by loans, which means that there are no investment opportunities);

(ii) assuming that income streams are modifiable by loans and other means (investment opportunities); and (iii) assuming that income streams are uncertain.

The great shortcoming of the first and second approximations, from the standpoint of real life, is the complete ruling out of uncertainty. This exclusion of the risk element was made in order to make the exposition simpler and to focus the reader's attention on the factors most relevant to the theory of interest. But in real life the most conspicuous characteristic of the future is in its uncertainty. Consequently, the introduction of the element of chance, or risk, will at once endow our hypothetical picture with the aspect of reality. (Fisher, 1930, p. 206)

Fisher (ibid.) was therefore conscious that uncertainty interferes strongly with the determination of the rate of interest in the real world, but, owing to his fascination with mathematics and to the quantitative relations he was seeking, he considered uncertainty a mere empirical perturbation that theory should disregard:

In the economic universe, as in astronomy, every star reacts on every other. From a practical point of view we cannot ignore the many perturbations. But from the theoretical point of view we gain clearness, simplicity and beauty, if we allow ourselves to assume certain other things equal, and confine our laws to a little part of the whole, such as the solar system. From such a point of view, the second approximation is the most instructive, rather than the first which rules out the important element of investment opportunity, or than the third which becomes too complicated and vague for any complete theoretical treatment. (Fisher, 1930, p. 497)

Obviously, Fisher's methodological choice has a tremendous impact on the realism of both his theory of interest and his analysis of the effect of an expected inflation rate on both real and nominal rates of interest. It was Keynes who, in 1936, proposed a "general theory" that fully considered the effects of uncertainty on interest rates. This gave rise to the post-Keynesian approach to endogenous money, where (expected or unexpected) inflation involves higher costs of production and therefore a proportional change in the demand for credit. This gives rise to an endogenous proportional change in the credit- money supplied by banks (the causality running from prices to credit-money, not the reverse). As a result, inflation has no effect on the equilibrium rate of interest, unless monetary authorities fight inflation by means of an increase in their policy rates of inter- est, as embedded in the Taylor rule and in inflation targeting policies. This is an important conclusion, because if the Fisher effect were observed empirically (see, however, Lavoie and Seccareccia, 2004, pp. 171-7), it would not result from Fisher's theorem, but from the willingness of monetary authorities to manage the rate of interest in order to keep infla- tion expectations under control. Against this kind of monetary policy, Keynes pointed out the positive effects that an expected rate of inflation entails on the inducement to invest, and, thereby, on effective demand:

The stimulating effect of the expectation of higher prices is due, not to its raising the rate of interest [. . .], but to its raising the marginal efficiency of a given stock of capital. (Keynes, 1936, pp. 142-3)

This suggests that, at least in an underemployment situation, expectations of higher prices could actually stimulate the economy instead of increasing its rates of interest.

See also:

Classical dichotomy; Endogenous money; Inflation targeting; Money illusion; Taylor rule.