Definition of the Fisher equation
Fisher equation is a mathematical formula used to estimate the relationship between nominal interest rate, real interest rate, and inflation.
It is commonly used to calculate the internal rate of return IRR, bonds and Yield to maturity YTM.
It was invented by Mr. Irving Fisher whose major work related to financial interests.
The Fisher equation says that the real interest rate is equal to the nominal interest rate less future expected inflation.
I denote the nominal interest rate
r denotes real interest rate
z denotes inflation rate
Then the Fisher equation is as follows:
r= I – z
Brief Explanation of the Fisher equation
For example: suppose Mr. A has a bank saving account. Now if the nominal rate is 5 %, inflation rate is 3 % then the real interest rate is 5% – 3% = 2% which means money is growing by 2 % only. The smaller the result of real interest rate the slower the growth of the saving would be.
Real interest rate defines the purchasing power of the investment as it grows. The higher the real rate of interest, the greater and faster the growth is.
It shows how inflation of money effects both nominal rate and interest rate both.
It is very useful for cost-benefit analysis purpose.