Which of the following narratives describe Fisher (Irving) effect?
A. Nominal interest rate is equal to a real interest rate plus an expected interest rate
B. Real interest rate is equal to nominal interest rate minus expected rate of inflation
C. Exchange rate differential between two currencies is explained by interest - inflation rate differential
D. Exchange rate differential between two currencies is explained by comparative cost advantage and purchasing power parity
Choose the most appropriate answer from the options given below:

Correct option is A

The Fisher (Irving) effect describes the relationship between nominal interest rates, real interest rates, and inflation. It is often summarized by the following equation:
Nominal interest rate = Real interest rate + Expected inflation rate.
(A) Nominal interest rate is equal to a real interest rate plus an expected inflation rate.
· True. This is a direct representation of the Fisher effect. The nominal interest rate compensates for both the real return on investment and the expected inflation rate, which erodes the purchasing power of money.
(B) Real interest rate is equal to nominal interest rate minus expected rate of inflation.
· True. This is the reverse equation of the Fisher effect, which solves for the real interest rate by subtracting the expected inflation rate from the nominal interest rate.
(C) Exchange rate differential between two currencies is explained by interest-inflation rate differential.
· True. This is related to the International Fisher Effect (IFE), which suggests that the expected change in the exchange rate between two currencies is proportional to the difference in nominal interest rates between the two countries. This is closely tied to inflation expectations.
(D) Exchange rate differential between two currencies is explained by comparative cost advantage and purchasing power parity.
· False. This is describing the Purchasing Power Parity (PPP) theory, not the Fisher effect. PPP explains exchange rate differentials based on the relative cost of goods between two countries, not by interest and inflation rates.
Information Booster:
1. Fisher Effect: The equation Nominal interest rate = Real interest rate + Expected inflation rate helps to understand how inflation expectations influence interest rates in an economy.
2. Real vs Nominal Interest Rate: The real interest rate is the rate of return adjusted for inflation, while the nominal interest rate does not account for inflation.
3. International Fisher Effect (IFE): The IFE states that the expected change in exchange rates between two currencies is based on the difference in nominal interest rates, which themselves are influenced by inflation expectations.
4. Inflation and Interest Rates: The Fisher Effect suggests that when inflation expectations rise, nominal interest rates must rise to maintain the real rate of return on investments.