in an article about monetary policyIn conclusion, to deal with rising inflation. interest rate (interest rate) must also be increased. The hope is that more people will save so that the amount in circulation decreases and inflation is suppressed.
The fundamental relationship between these two economic indicators was first coined by the US economist Irving Fisher. The relationship between the two is known as the Fisher equation. Understanding the Fisher equation below We hope you have a better understanding of why rising inflation is being suppressed by rising interest rates.
Definition of the Fisher Equation
Fisher’s equation is an equation that describes the relationship between inflation and interest rates. According to this theory, the bank interest rate is divided into two parts: the real interest rate (rreal interest rate) and the nominal interest rate (nominal interest rate).
nominal interest rate is the amount of bank interest that is not deducted by inflation. This type of interest is often displayed on your bank’s screen or website when you want to apply for a loan or save and deposit money at the bank.
on the other hand, real interest rate is the bank interest rate that decreases with inflation or changes in purchasing power. Therefore, real interest rate go down if An increase in inflation does not come with an increase. nominal interest rate. Basically, you have to calculate this type of interest yourself. Because the bank won’t show it to you.
This theory was first coined by US economist Irving Fisher, who lived during the Great Depression. In addition to this concept Fisher also perfected previously existing concepts of finance, such as: money supply theory (QTM/Money Supply Theory). Both the Fisher equation and the QTM are still in use today.
Fisher equation formula
The Fisher equation formula is Real Interest Rate = Nominal Interest Rate − Inflation Rate.
This is equivalent to:
Nominal Interest Rate = Inflation + Real Interest Rate
You record your deposit at the bank with a deposit of IDR 10,000,000 and interest per month or 6% per year, so the total money you deposit will be at IDR 10,600,000 at the end of the year (excluding taxes).
Meanwhile, the annual inflation rate is 4%, so the total real interest rate you get is:
Real interest rate = 6%− 4%
When changing to name:
interest rate What you actually earn in 1 year is 2% * IDR 10,000,000 or IDR 200,000 which means It is possible that your deposit has increased by INR 600,000. However, due to inflation, the value of 600,000 is equivalent to the previous value of INR 200,000.
For example, if IDR 600,000 at the beginning of the year could buy 3 clothes, now IDR 600,000 at the end of the year could only be used to buy 1 shirt. When inflation increases The interest rate required must be increased.. Therefore, you can use the same amount of money to buy the same amount of goods, or not much different from the original.
using the Fisher equation
The Fisher equation is still widely used in both macro and microeconomics:
1. Monetary policy
in monetary policy This equation is applied by adjusting the standard interest rate when inflation is rising. which is based on the assumption that real interest rate It is not affected by monetary policy or increases in inflation.So an increase in inflation must have an impact. nominal interest rate.
2. Time value of money
In the concept of time is money (Time value of money) The lender has an opportunity cost to sacrifice if lending money to someone else. For example, you lend your friend Rp. 100,000 the next month.
at the same time You need to buy 60GB data plan, that data package and IDR 100,000 is your opportunity cost. to compensate for the loss of this opportunity You take interest in your friends.
The problem is IDR 100,000 next month may not be used to buy 60GB data package due to 10% inflation rate. The price of 60GB data package will be 110,000 IDR. That’s why you should use 10% interest rate with your friends to offset the opportunity cost.
Basically The real profit from investing in bonds is derived from a % coupon or nominal interest rate – value. inflation forecastTherefore, if interest rates remain constant while real inflation is high The profit that investors receive will also be less.
For example, you buy a bond in 2022 for $100 with a 6% coupon. If inflation in 2022 is 4%, then the real profit (real interest rate) you will earn is 2% (6%-4%)
However, if in 2023 inflation increases by 5% and your coupon remains 6% per annum, the real profit you will earn will drop to 1%. As a result, bond investors are more likely to switch to bonds. issued when inflation or interest rates increase Therefore, the relationship between Interest rates are linked to bonds. negative previously published
4. Forex Trading
The subsequent development of the Fisher equation is often used for Forex trading. In the above discussion it is clear that An increase in inflation should be followed by a slight increase in interest rates. in order not to reduce the purchasing power of the people
in the world of forex The stated interest rate is the “price” or profit that can be made by holding that country’s currency. On the one hand, it means that the higher nominal interest rate offered by country High potential profits that can be received by forex traders owning that country’s currency. Therefore, it is not surprising that developing countries such as Indonesia increase their benchmark interest rates when this indicator in the United States increases.
However, due to high inflation expectations and high risks that come with high nominal interest rate in emerging markets Forex traders tend to choose countries with lower interest rates. but with lower inflation and a more mature economy
for people Knowledge of Fisher’s equation will be helpful in understanding the context of why Indonesian banks and commercial banks increase interest on savings and loans when inflation is rising.
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