The Fisher Effect:

The nominal or market interest rate is primarily determined by expected inflation!

Consider the following equation:

i = r + premium for expected inflation

Where:

i is the nominal or market rate of interest

r is the real rate of interest

Example:

Let us assume a 3 % expected rate of inflation.

Historically, the real rate of interest has exhibited very little variability around an average of approximately 2 - 3 %. Let us assume a 2 % real rate of interest.

Plug these estimates into the Fisher equation:

i = 2 % + 3 % = 5 %

By using this equation, the Fisher Effect, we get an idea of the nature of market interest rates.