The Fisher Effect and the Japanese Crises
The Fisher effect was proposed by Fisher by Irving Fisher in 1930. The effect establishes the relationship between short-term interest rates and expected future inflation rates. It also establishes the relationship between inter-country interest rates and inflation rates and has an effect on the international flow of capital. According to the fisher effect, nominal interest rates consist of two elements, namely, the real interest rate and expectations about future inflation. In effect, the interest rates that are often reported in the financial press are nominal rates only and do not reflect the real interest rates. The fisher effect can be represented mathematically as follows:
1 + Nominal rate = (1 + Real rate)(1 + Expected inflation rate)
1 + r = (1 + a) (1 + i)
Or
r = a + i + ai(1)
Where
a is the real interest rate;
i, represents the expected future inflation rate;
r is the short-term nominal interest rate.
We can approximate equation (1) to look as follows: r = a + i, where a and i remain as defined above. (Shapiro, 2003: p. 131)
From the foregoing, if the required rate of return on a risk free investment is say 5% and the expected inflation, rate is 5% as well, then the fisher effect proposes that the nominal interest rate that will be stated in the financial press should be given by
1+ r = (1+0.05)(1+0.05) = 1.1025 implying that r = 10.25% which is approximately equal to 10% (5 + 5), if we consider the approximation stated in Shapiro.
An important implication of the fisher effect is therefore the fact that nominal interest rates reflect fully all available information concerning expectations of future inflation. The fisher proposition has been widely accepted by economists and financial analysts and has played an important role in monetary, finance and macroeconomic theories. The generalized version of the fisher effect is usually expressed in terms of interest rates and inflation rates in two countries and takes into account the theory of arbitrage which states that the prices of assets of similar value should be equal in different markets, otherwise market participants will bid down prices where the prices are high and bid up prices in the market where prices are low by buying from the low price market and selling in the high price market. Applying similar reasoning to returns on financial assets, the fisher effect postulates that the returns on financial assets should be equal across countries, that is real interest rates must be equal across countries, otherwise capital will flow from a country with low real interest rates to a country with higher real interest rates. This will bid up interest rates in the country where interest rates are low and reduce interest rates in the country where they are high until equilibrium is attained. Following from this reasoning, the generalized version of the Fisher effect can be stated as follows:
(2).
Where and represent the home and foreign nominal interest rates, respectively and and represent the home and foreign inflation rates, respectively. Equation (2) is in effect saying that in equilibrium, with no government intervention, the nominal interest rate differential should be equal to the anticipated inflation differential between the home and foreign country. This implies that interest rates should be higher in countries with higher inflation and should be lower in countries with lower inflation. This makes sense if we consider the implications of the capital asset pricing model (CAPM), which states that the return on a risky asset should constitute the return on a risk free asset plus a risk premium. High inflation implies high risk and thus investors in high inflation countries demand higher returns on investment so as to compensate for the higher risk that comes as a result of inflation. The exact form of the relationship between home and foreign interest and inflation rates can be written as follows:
(3)
Equation (2) can be derived from equation (3) by subtracting 1 from both sides of equation (3) and assuming that and are small as follows:
and = and therefore,
.
According to Crowder and Dennis the fisher effect has received little empirical support. For example, empirical evidence shows that the estimated coefficient on expected inflation which is expected to be equal to unity is significantly different from unity. Crowder and Dennis attribute findings of a coefficient on inflation below unity to substantial adjustments in real interest rates in response to changes in expected inflation. This reasoning is supported by Levi and Makin (1978); Melvin (1982); and Peek and Wilcox (1983) who show that Mundell-Tobin effects (that is, the decline in the marginal product of capital resulting from the real balance response to inflation) may have considerable significance. On the other hand Lucas (1980) and Fried and Howitt (1983) propose that “in models characterized by super-neutrality, inflation will not affect real rates in this manner over a long time”. Despite these discrepancies, some studies have found a significant relationship between inflation and nominal interest rates. For example, Wallace and Warner employing cointegration tests find significant support for both the fisher effect and the expectations hypothesis of the term structure of interest rates. It is difficult for nominal interest rates to be negative but the central bank may decide to set negative interest rates when the level of inflation is very low so as to achieve a desired equilibrium position. However, the actions that households would take in anticipation of negative interest rates may generate inflation instead. “The Japanese banking system has been losing money since the early 1990s due to heavy credit costs and the increase outflow of capital”. As a result, the government has been suffering from budget deficits which arise as a result of its attempt to provide guarantees for banking sector liabilities so as to prevent the banking sector from running into a crises. In addition, the Central Bank was unable to carry out monetary policy through the use of interest rates resulting from a zero lower bound on nominal interest rates. There is also an accelerating deflation (a situation whereby the supply of money is lower than the demand). As at 2002, borrowers in Japan were facing a very high interest cost resulting from the “gradual acceleration of deflation” and Fukao proposed that increasing the lending rate would have led to a further deterioration in the economy. Deflation in Japan therefore made nominal interest rates to be very low, which in turn made returns from investments to be very low, while borrowing cost was very high. The solution proposed by Fukao, is that, deflation had to be reduced and inflation increased a bit, this would in turn raise nominal interest rates. Japan's situation is consistent with the fisher effect where huge capital flights were expected to take place as a result of low returns on investments in Japan. Fukao proposed two solutions to the Japanese case: namely massive open market purchase of high-quality real assets (consistent with an expansionary monetary policy) and a “negative nominal interest rate policy by levying tax on all government-guaranteed yen financial assets”.
BIBLIOGRAPHY
Bassetto M. (2004). Negative nominal interest rates. retrieved from:
http://www.nber.org/~bassetto/research/negrates/negrates.pdf
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Crowder, W. J., Hoffman, D. L. (1996). The Long-run Relationship between nominal interest rates and inflation: the fisher equations revisited. Journal of Money, Credit and Banking, vol. 28.
Fukao, M. (2003). Financial Strains and the Zero Lower bound: the Japanese experience. Business Working Paper No 141. Bank for International Settlements.
Jaffe, J. F., Mandelker, G. (2001). The fisher effect for risky assets: an empirical investigation. The Journal of Finance. Pp. 447-458.
Ross S.A., Westerfield R.W., Jaffe J. (1999). Corporate Finance. Fifth Edition. McGraw-Hill International Ediction Finance Series.
Shapiro, A. C. (2003). Multinational Financial Management. (7th ed) Wiley and Sons Inc.
Wallace, M. S., Warner, J. T. (2001). The Fisher Effect and the Term Structure of Interest Rates: Tests of Cointegration. The Review of Economics and Statistics. Pp. 320-324.
