Devolution of the Fisher Equation: Rational Appreciation to Money Illusion

Abstract:     
In Appreciation and Interest Irving Fisher (1896) derived an equation connecting interest rates in any two standards of value. The original Fisher equation (OFE) was expressed in terms of the expected appreciation of money [percent change in E(1/P)] whereas the ubiquitous conventional Fisher equation (CFE) uses expected goods inflation [percent change in E(P)]. Since Jensen's inequality implies the non-equivalence of the two equations, the OFE is not subject to standard criticisms of non-rationality leveled against the CFE. The puzzling substitution of inflation for expected money appreciation in Fisher (1930) is resolved by taking into account Fishers theory of money illusion.

Keywords: Fisher equation, Fisher hypothesis, Fisher effect, money illusion, nominal interest rate, purchasing power of money, value of money

JEL Classifications: E40, B00, B31

Working Paper Series