Fisher equation
/ FISH-er /
Suppose a bank offers you 6 percent interest on your savings, and you feel pleased. But if prices are rising 6 percent a year, the extra money you earn buys exactly nothing more than your original deposit would have a year ago. Your money grew in number but not in power. To know whether interest is really making you richer, you must subtract inflation from it — and that simple subtraction is the heart of the Fisher equation.
The Fisher equation links nominal and real interest rates through inflation. Its everyday form is: real interest rate is approximately the nominal interest rate minus the inflation rate. The nominal rate is the headline number the bank quotes; the real rate is what you actually gain in purchasing power. So 6 percent interest with 4 percent inflation is only a 2 percent real return. Rearranged for lending, it says the nominal rate roughly equals the real rate plus expected inflation, because lenders add an inflation premium to protect themselves.
The Fisher equation is the bridge between the world of money and the world of real value, and it explains a lot. It tells you a savings account paying less interest than inflation is quietly losing you money. It explains why interest rates rise when inflation is expected. And it reveals the real burden of debt: high inflation is a gift to borrowers and a loss to lenders. The key caveat is that what matters for decisions today is expected inflation, which nobody knows for sure — surprise inflation, higher or lower than expected, is what reshuffles wealth between borrowers and lenders after the fact.
A savings account pays 3 percent nominal interest, but inflation runs 5 percent. The real interest rate is roughly 3 minus 5 = minus 2 percent. Your balance grows on paper, yet each year it buys about 2 percent less — you are gently losing money by saving.
Real return = nominal interest minus inflation. Below zero, saving loses.
What guides decisions is expected inflation, which is uncertain. Unexpected inflation, higher or lower than forecast, is what actually transfers wealth between borrowers and lenders.