FISHER THEORY

Interest Rates and Inflation



Interest Rates and Inflation

Inflation Rate

To motivate people to pay money, you need to be offered a premium or interest, that allows to increase consumption in the future as being to provide, would be sacrificing current consumption in order to consume more in the future. What matters is not how much money you have, but you can make use of the same. To get the actual value is necessary to deflate (divide by [1 + p]) the nominal values. If we define as “i” as nominal interest rate and “r” as real interest rate, then the latter would be obtained by deflating the first. i = nominal interest rate for the period r = real interest rate for the period p = rate of inflation for the period Then deflating the nominal interest rate we get the real interest rate: rp (real interest rate by the rate of inflation) represents compensation for the loss of purchasing power of their interests.

Now if we want to calcute the Cash Flow (CF) and derive Fisher's equation than we have first calculate “r”. Suppose that rate of time preference to sacrifice one hundred pounds worth of current consumption is one hundred and five pounds in one year's time. Also assume that real interest rate is 5 percent, that is:

Through this equation we got the value of “r” which is 5 percent.

Absence of Inflation

Cash flow analysis should be carried out both in the short and long term. In a long-term cash flow analysis is the understanding of time preference at the disposal of the funds or, in other words, the concept of time value of money. This concept consists in the fact that money has value, which is defined as the time factor, ie, the resources available to today is worth more than the same resources, obtained through a (substantial) amount of time.

The concept of cost of funds affects a wide range of business solutions related to investment. Understanding this concept largely determines the efficiency of decision making. This provision is important because the cost of funds is often a mistake to reduce the loss from inflation. Indeed, under the influence of the inflation factor the purchasing power of money decreases. But the principle is the understanding that even in the absence of inflation, still we have value of cash, determined previously marked preference for time and opportunity to earn additional income from earlier investments.

Now if we assume, that there is no inflation then situation will change. In the absence of inflation we will use the following equation to calculate the CF in the absence of inflation:



=100 (1+ 0.05)

CFt+1 =105

It shows, that in the absence of inflation CF will increase from 100 to 105 i.e., showing appreciation in the value of money. Lets that this is equation (3).

Rise in Inflation

Now if we look at another scenario i.e., lets say that prices are increasing at the rate of 8 percent. This means that inflation is increasing and now people have to ...