The Fisher Hypothesis deals with nominal interest rate, real interest rate and inflation. It says that in the long run the inflation and nominal interest rate move together which otherwise mean that the real interest rates stay stable in the long run. Fisher Hypothesis is also called Fisher Effect that was proposed by the famous economist Irving Fisher.
Mathematically the Fisher Hypothesis can be put into the following equation:
n = i + r
Where,
n stands for the nominal interest rate
i stands for the rate of inflation
r stands for the real interest rate
The above stated equation is an approximation on the perfectly correct equation. There is not much difference between the correct equation and approximated equation unless and until either of the interest rate or inflation soars high. The perfectly correct mathematical representation of Fisher hypothesis is:
1+n = (1+i)(1+r)
According to the Fisher Hypothesis, the value of n and i move together and consequently the value of r also remains stable in the long run.
The principle of monetary neutrality says that the rate of inflation is raised by the rate of money growth increment but this change does not affect any real variable. The effect of money on interest rates can be explained with the application of this principle. The interest rates play an important part for macroeconomists to understand the economy. This is so because the economists link the future economy with the present economy through the investments and savings made in the present.
To understand the Fisher Hypothesis properly, it is necessary to understand the concepts of nominal interest rate and real interest rate. The nominal interest rate is usually the interest that we get to hear from the banks. The real interest rate gives the corrected interest rate value of nominal interest rate after considering the effect of inflation. It can also be said that the real interest rate is obtained by subtracting the expected inflation rate from the nominal interest rate.