Explain the Fisher equation and its implication for nominal interest rates.

• A. The nominal rate equals the real rate minus expected inflation.
• B. The nominal rate equals the real rate plus expected inflation: i ≈ r + π^e. It implies higher expected inflation raises nominal rates.
• C. The nominal rate equals the real rate plus actual inflation.
• D. The Fisher equation states that inflation does not affect nominal rates.

Answer: (B)

The Fisher equation shows how the nominal interest rate is built from two pieces: the real return lenders seek and the expected loss of purchasing power from inflation. In the common form, the nominal rate is approximately the sum of the real rate and expected inflation: i ≈ r + π^e. This means that if the real rate stays the same but people expect higher inflation, the nominal rate rises correspondingly. For example, with a real rate of 3% and expected inflation of 2%, the nominal rate is about 5%; if expected inflation moves to 4%, the nominal rate goes to about 7%. The precise relationship is (1+i) = (1+r)(1+π^e), which expands to i ≈ r + π^e when the numbers are small; the approximation is why this form is taught.

What this implies is that inflation expectations drive nominal rates. Choosing actual inflation rather than expected inflation shifts the perspective because actual inflation may differ from what was anticipated, altering the real return lenders actually receive. The option that claims expected inflation is not part of the Fisher relation is the one that doesn’t fit, and the idea that inflation has no effect on nominal rates contradicts the whole relationship.