Inflation and Interest Rates

Written by Miroslav Marinov

Miroslav Marinov

Miroslav Marinov, a financial news editor at TradingPedia, is engaged with observing and reporting on the tendencies in the Foreign Exchange Market, as currently his focus is set on the major currencies of eight developed nations worldwide.

, | Updated: October 23, 2025

Inflation and interest rates are closely related and are frequently discussed together in economics. Inflation refers to the rate at which prices for goods and services rise. The interest rate represents the amount of interest a borrower pays to a lender and is generally influenced by central banks.

To clarify what interest rates are, let’s pretend you deposit money in a bank. The bank uses your funds to provide loans to other customers. In return for the use of your money, the bank pays you interest. Similarly, when you purchase something with a credit card, you pay the credit card company interest for using the money it provided for your purchase. In general, interest is money that a borrower pays a lender for the right to use that money. The interest rate is the percentage of the total due that is paid by the borrower to the lender.

Example

Since we are also discussing inflation, consider the following situation. Let’s say the overall price level of products offered in a market increased by 3% over the past 12 months. If a household spent $1,000 during the first month on all household expenses, they would need to budget $1,030 during the last month for exactly the same quantity of goods and services. Prices of individual items may have increased at different rates and some prices may even have declined, but overall the household must now budget about $30 more per month. If their income after taxes does not increase by that amount, they will have to save less, substitute less expensive items or incur debt.

Understanding the relationship between money, inflation and interest rates requires grasping the difference between the nominal and the real interest rate. The nominal interest rate is the one offered by your local bank. For example, if you have a savings account, the nominal interest rate shows how fast the amount of money in your account will increase over time. On the other hand, the real interest rate corrects the nominal rate for the effect of inflation, thus showing you how much the purchasing power of your savings account will rise over time.

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Fisher Effect

Irving Fisher proposed that the real interest rate is independent of monetary measures, particularly the nominal interest rate. The Fisher Effect is expressed by the equation: r = i − π. This means the real interest rate (r) equals the nominal interest rate (i) minus the rate of inflation (π). So, if your bank account pays you 3% per year in interest on your deposits, but inflation over the next year increases the price level by 1%, then, even though you will have 3% more dollars a year from now, you will have only 2% more purchasing power.

From the Fisher equation, you can see that if the real interest rate is held constant, an increase in the inflation rate must be accompanied by an equal increase in the nominal interest rate. The Fisher Effect is evidence that purely monetary developments will have no effect on a country’s relative prices in the long run. In the short run, however, the Fisher Effect does not necessarily hold, as the nominal rate may need time to adjust if inflation is unexpected.