The Fisher Effect
To determine true return on a company's investment, the financial manager (FM) must be able to determine the real interest the company's investments are achieving, regardless of inflation. Irving Fisher theorized in his work The Theory of Interest: As Determined by Impatience to Spend Income and Opportunity to Invest it? that real interest is the price at which the supply of capital is equal to the demand for capital. The supply is dependent on peoples willingness to save and demand is dependent on peoples willingness to invest in viable opportunities (cited in Brealey, 2005, p. 626). This can be further approximated by the equation: n = r + i
where n is the nominal interest rate, r is the real interest rate, and i is the rate of inflation (Chrisholm, 2003, p. 45). The demand for real interest remains stable regardless of inflation. This means that in times of higher inflation investors demand a higher nominal interest rate. In fact, for a 1% increase in inflation, investors will demand a 1% higher nominal interest rate. This is true irrespective of monetary policies such as balanced budgets and declining private borrowing (Bartlett, 2004, p.19). In times of higher inflation the investor demands a higher nominal interest rate to cover the loss of value due to inflation. Understanding of the Fisher Effect can be essential to multinational companies, which operate in countries with differing inflation rates. FM's must forecast several countries exchange rates and inflation rates to accurately budget future growth. The Fisher Effect enables a company to evaluate two opportunities in countries with differing inflation rates and offering different nominal interest rates. For example, if country A is offering a 20% nominal return with 7% inflation and country B is offering 17% nominal return with a 6% inflation, application of the Fisher equation concludes that country A has a higher real return at 13% (Mannino, 1992, p. 39). Long Term...
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