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DEVOLUTION OF THE FISHER EQUATION: Rational Appreciation to Money Illusion

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  • James R. Rhodes

    (National Graduate Institute for Policy Studies)

Abstract

In Appreciation and Interest Irving Fisher (1896) derived an equation connecting interest rates in any two standards of value. The original Fisher equation (OFE, 1896) was expressed in terms of the expected appreciation of money (the real return on money) whereas the ubiquitous conventional Fisher equation (CFE, 1930) uses expected inflation. Since the OFE is based on the value of money (1/P) it is not subject to standard criticisms of irrationality leveled against the CFE. Fisher’s puzzling substitution of lagged inflation for expected money appreciation in 1930 is resolved by taking into account his theory of “money illusion.”

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Bibliographic Info

Paper provided by National Graduate Institute for Policy Studies in its series GRIPS Discussion Papers with number 07-05.

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Length: 31 pages
Date of creation: Jun 2006
Date of revision: Sep 2007
Handle: RePEc:ngi:dpaper:07-05

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Keywords: Fisher equation; Fisher hypothesis; Fisher effect; money illusion; nominal interest rate; purchasing power of money; value of money.;

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  1. Frederic S. Mishkin & John Simon, 1995. "An Empirical Examination of the Fisher Effect in Australia," NBER Working Papers 5080, National Bureau of Economic Research, Inc.
  2. Ioannis Karatzas & Martin Shubik & William D. Sudderth & John Geanakoplos, 2003. "The Harmonic Fisher Equation and the Inflationary Bias of Real Uncertainty," Cowles Foundation Discussion Papers 1424, Cowles Foundation for Research in Economics, Yale University.
  3. Hutchison, Michael M & Keeley, Michael C, 1989. "Estimating the Fisher Effect and the Stochastic Money Growth Process," Economic Inquiry, Western Economic Association International, vol. 27(2), pages 219-39, April.
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  6. Wallace, Myles S & Warner, John T, 1993. "The Fisher Effect and the Term Structure of Interest Rates: Tests of Cointegration," The Review of Economics and Statistics, MIT Press, vol. 75(2), pages 320-24, May.
  7. Crowder, William J & Hoffman, Dennis L, 1996. "The Long-Run Relationship between Nominal Interest Rates and Inflation: The Fisher Equation Revisited," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(1), pages 102-18, February.
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  14. Rose, Andrew Kenan, 1988. " Is the Real Interest Rate Stable?," Journal of Finance, American Finance Association, vol. 43(5), pages 1095-1112, December.
  15. Blejer, Mario I. & Eden, Benjamin, 1979. "A note on the specification of the fisher equation under inflation uncertainty," Economics Letters, Elsevier, vol. 3(3), pages 249-255.
  16. William J. Crowder & Mark E. Wohar, 1999. "Are Tax Effects Important in the Long-Run Fisher Relationship? Evidence from the Municipal Bond Market," Journal of Finance, American Finance Association, vol. 54(1), pages 307-317, 02.
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