Inflammation, money supply, and interest
The relationship between the growth of monetary aggregates and nominal interest and inflation is one of the most documented relationships in economic literature. Fisher attempted to float a theory that linked relates to the supply of money and level of inflation. According to Fisher, “increase in the growth rate of money supply results in increase in inflation and increase in nominal interest rate which matches an increase in the inflation rate.” He further suggests that the summation of the anticipated proportion of inflation and actual interest rate equates to a nominal interest rate of any period. It was established that the interest rate not adjusted for inflation ought to be split into two distinct components, namely, expected and real inflation rate. However, Fisher continues to say there is a small relationship that affects interest rates and inflammation levels and that inflation was influenced more by real factors such as capital productivity. Fischer further explains how money and inflation correlate by introducing the International Fischer Effect theory (IFE). IFE theory postulates that countries with relatively high-interest rates will have their currencies decline in value since the rate of interest rate not adjusted for inflation indicates the expected terms of inflation.
A study was conducted to establish a linkage between the interest rate and unadjusted inflation. Canada’s inflation rate data from 1990-2017 was compared to that of the U.S. from 1990 to 2018. Fisher established that inflationary supposition unincluded in the interest rates. In Canada. There was a correlation of 0.90 between price changes and long-term interest rates in 27 years, while in America, there was a correlation of 0.97 in 28 years. In the case of high-interest rates, the demand for credit will decline, thereby having adverse effects on the economy (Samimi, A. J., & Jamshidbaygi, 2011)
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In the linkage of exchange rates with changes in inflation and interest rates, IFE theory stipulates that the future spot exchange rate should be obtained from the instantaneous rates of nominal interest (Ali Et al., 2015). A study was done on the long-run correlation between inflation rate and Euro currency interest proportion in 9 European countries and the U.S. From the results obtained; it was inferred that there existed a reasonably secure link in the interest rate and inflammation rates. Sasongko, G., & Huruta, A. D (2018) also investigated this relationship in South Africa to test the hypothesis. The data were obtained between March 2001 and August 2007. The empirical verification of the short-run Fischer effect was not done, but there existed a long-run association relating inflation rates to accrued interest accrued in the long-run. The long-run adjustment was as a result of changes adopted in the framework. Fischer’s theory of interest is playing a pivotal role because it brings out the “ between interest rate and inflation,” which brings about the idea of a fiscal plan which ought to be designed to focus on controlling inflation and thereby promote investment and economic growth.
Reference
Ali, T. M., Mahmood, M. T., & Bashir, T. (2015). Impact of interest rate, inflation, and money supply on exchange rate volatility in Pakistan. World Applied Sciences Journal, 33(4), 620-630.
Samimi, A. J., & Jamshidbaygi, S. (2011). Budget deficit and inflation: A sensitivity analysis of inflation and money supply in Iran. Middle-east journal of scientific research, 8(1), 257-260.
Sasongko, G., & Huruta, A. D. (2018). Monetary policy and the causality between inflation and money supply in Indonesia. Business: Theory and Practice, 19, 80-87.