Please help me!

Hi,

The fisher model looks at the relation between the real and nominal interest rates – essentially if there has been inflation in the economy (think of a rise in general prices), the value of money essentially comes down (think £1 in 2005 vs £1 in 2021)
What then happens is the REAL rate of return for any investment is compromised

If I issued a loan of £100 with an interest rate of 5%. I would need £5 annually as my real return to satisfy the 5% rate.

If there was no inflation in the economy, the £5 satisfies the condition of 5%

However, due to general inflation – the £5 interest received has actually lost value over the past year.

In order to incorporate inflation to find out what we must receive as return, we use the fisher formula:

( 1 + Real Rate ) * ( 1 + Gen. inflation) = (1 + Nominal Rate)

So, in this example if I wanted 5% REAL return, but there was a general inflation rate of 3% in the economy, the nominal rate that I should ask for would be

( 1+ 0.05 ) * (1 + 0.03 )

= 1.0815

Therefore, if I were to issue a loan of £100 and wanted a REAL return of 5%, in an economy where the general inflation is 3%, I would ask for the interest at 8.15%, to compensate for the inflationary effect on the currency value.