Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

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What does the Fisher effect state about nominal interest rates?

They equal the sum of real interest rates plus a premium for anticipated inflation
They equal the sum of real interest rates plus a premium for the risk of unanticipated inflation
They equal the sum of real interest rates plus a premium for anticipated taxation
They equal the sum of real interest rates plus a premium for the risk of unanticipated taxation

The correct answer is: They equal the sum of real interest rates plus a premium for anticipated inflation

The Fisher Effect posits that nominal interest rates consist of the real interest rate plus an adjustment for anticipated inflation. This relationship suggests that when inflation is expected to rise, nominal interest rates will also increase to compensate investors for the loss of purchasing power associated with inflation. The core idea is that the real interest rate reflects the true profitability of an investment in terms of purchasing power, while the anticipated inflation component allows lenders to maintain their returns in nominal terms despite inflation eroding the currency's value. This concept is particularly important for understanding how inflation influences interest rates in the economy. By recognizing the direct relationship between nominal interest rates and both real interest rates and anticipated inflation, it helps investors and policymakers make informed decisions regarding investments and monetary policy.