The formulas used in the calculations are:
\[ \text{Real Interest Rate (Approximate)} = \text{Nominal Interest Rate} - \text{Expected Inflation} \]
\[ \text{Real Interest Rate (Exact)} = \frac{\text{Nominal Interest Rate} - \text{Expected Inflation}}{1 + \frac{\text{Expected Inflation}}{100}} \]
The Fisher effect is an economic theory that explains the relationship between the nominal interest rate and the real interest rate. The nominal interest rate is the interest rate you see on the market, while the real interest rate is the nominal interest rate after stripping away the expected inflation. The Fisher effect states that the real interest rate equals the nominal interest rate minus the expected inflation rate.
Let's assume the following:
Calculate the real interest rate using the approximate formula:
\[ \text{Real Interest Rate (Approximate)} = 5\% - 2\% = 3\% \]
Calculate the real interest rate using the exact formula:
\[ \text{Real Interest Rate (Exact)} = \frac{5\% - 2\%}{1 + \frac{2\%}{100}} = \frac{3\%}{1.02} \approx 2.94\% \]
Therefore, the approximate Real Interest Rate for this example is 3%, and the exact Real Interest Rate is approximately 2.94%.