The principle that the monetary authorities should raise nominal interest rates by more than the increase in the inflation rate is known as:
The correct answer and explanation is:
The principle that the monetary authorities should raise nominal interest rates by more than the increase in the inflation rate is known as the Fisher Effect or more specifically the Fisher Principle.
Correct Answer:
Fisher Effect (Fisher Principle)
Explanation (300 words):
The Fisher Effect, named after economist Irving Fisher, explains the relationship between nominal interest rates, real interest rates, and inflation. According to this principle, the nominal interest rate adjusts to expected inflation so that the real interest rate (the nominal rate minus inflation) remains relatively stable.
When inflation rises, lenders want to be compensated for the loss of purchasing power, so nominal interest rates should increase by more than the inflation increase. This ensures that the real interest rate—the true cost of borrowing or the real yield on lending—does not decrease unintentionally.
For example, if inflation increases by 2%, the nominal interest rate should rise by more than 2% to keep the real interest rate from falling. If monetary authorities only raise nominal interest rates exactly by the inflation rate increase, the real interest rate would remain unchanged. But if they do not raise nominal rates by at least the inflation rate, real rates would fall, encouraging excessive borrowing and spending, potentially overheating the economy and further fueling inflation.
Central banks use this principle to maintain control over inflation and economic growth. By raising nominal rates more than the inflation increase, monetary policy becomes tighter, reducing spending and investment, which helps bring inflation back down.
The Fisher Effect is also important for investors, as it helps them anticipate how interest rates might change in response to inflation and adjust their portfolios accordingly.
In summary, the Fisher Effect guides monetary authorities to raise nominal interest rates more than the inflation increase to preserve real interest rates, control inflation expectations, and maintain economic stability. This principle underpins many central bank decisions on interest rate policy in inflationary environments.