The Fisher Effect states the relationship between the nominal rate (r), the real rate (r*), and inflation (h). Suppose r= 5% and h = 4%

Many would say that the nominal rate is 9%. Is this true? Explain in terms of the relationship between the real rate and the inflation rate over time.
What will be an ideal response?

Answer: The simplified version of the Fisher Effect states that r = r* + h, such that r = 5% + 4% = 9%. However, this is not a precise accounting of the nominal rate's value. The correct formula is:
r = r* + h + (r* × h). This gives r = 5% + 4% + (5% × 4%) = 9.2%. The product of the real rate and the inflation rate can be thought of as the additional compensation needed for the fact that the interest being earned during the year is also subject to inflation or a loss of purchasing power at the end of the year.