According to the Fisher effect, if a lender and a borrower would agree on an interest rate of 8 percent when no inflation is expected, they should set a rate of _______ when an inflation rate of 3 percent is expected.
A) 2 percent
B) 5 percent
C) 8 percent
D) 11 percent

Question

Quizplus · Accepted Answer

The Fisher effect states that the real interest rate is equal to the nominal interest rate minus the expected inflation rate. If both parties agree on an 8% interest rate with no inflation, when a 3% inflation is expected, they should adjust the nominal interest rate to maintain the real interest rate. The formula for the Fisher effect is (1 + nominal rate) = (1 + real rate) * (1 + inflation rate). Using this, if the real rate is 8% and inflation is 3%, the nominal rate should be adjusted to approximately 11% to maintain the real interest rate.

According to the Fisher Effect, If a Lender and a Borrower