Question

The Fisher effect describes interest rate parity; it's the law of one price applied to interest rates. Interest rates vary to take into account anticipated differences in inflation levels. What does the Fisher effect describe?

1) Interest rate parity
2) The law of one price
3) Differences in inflation levels
4) Anticipated changes in interest rates

Answer 1

The Fisher effect relates to the anticipated changes in interest rates by incorporating expected inflation rates into nominal interest rates, thereby affecting the real interest rate paid by borrowers or received by lenders.

Step-by-step explanation:

The Fisher effect primarily describes the relationship between nominal interest rates, real interest rates, and inflation rates. When considering the options provided in the question, the best match for what the Fisher effect describes is option 4: Anticipated changes in interest rates.

For instance, if a borrower takes out a loan with a fixed nominal interest rate and inflation increases beyond expectations, the real interest rate that the borrower pays would decrease, benefiting the borrower but harming the lender.