Investments, tenth edition

  The Equilibrium Nominal Rate of Interest 

 We’ve seen that the nominal rate of return on an asset is approximately equal to the real 

rate plus inflation. Because investors should be concerned with real returns—the increase 

in purchasing power—we would expect higher nominal interest rates when inflation is 

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6/18/13   8:03 PM

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  C H A P T E R  

5

  Risk, Return, and the Historical Record 

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higher. This higher nominal rate is necessary to maintain the expected real return offered 

by an investment. 

 Irving Fisher (1930) argued that the nominal rate ought to increase one-for-one with 

expected inflation,  E(i ).  The so-called Fisher equation is   

 

rn 5 rr 1 E(i) 

 (5.4)   

 The equation implies that when real rates are reasonably stable, changes in nominal rates 

ought to predict changes in inflation rates. This claim has been debated and empirically 

investigated with mixed results. Although the data do not strongly support the Fisher 

equation, nominal interest rates seem to predict inflation as well as alternative methods, 

in part because we are unable to forecast inflation well with any method. It is difficult to 

determine the empirical validity of the Fisher hypothesis because real rates also change 

unpredictably over time. Nominal interest rates can be viewed as the sum of the required 

real rate on nominally risk-free assets, plus a “noisy” forecast of inflation. 

 In Chapter 15 we discuss the relationship between short- and long-term interest rates. 

Longer rates incorporate forecasts for long-term inflation. For this reason alone, inter-

est rates on bonds of different maturity may diverge. In addition, we will see that prices 

of longer-term bonds are more volatile than those of short-term bonds. This implies that 

expected returns on longer-term bonds may include a risk premium, so that the expected 

real rate offered by bonds of varying maturity also may vary. 

 

 

     a.   Suppose the real interest rate is 3% per year and the expected inflation rate is 8%. According to the 

Fisher hypothesis, what is the nominal interest rate?  

    b.   Suppose the expected inflation rate rises to 10%, but the real rate is unchanged. What happens to the 

nominal interest rate?   

 CONCEPT CHECK