According to Irving Fisher, the real rate of interest is the most important price in the economy. This is because real rate of interest provides the worth of consumption at present in terms of consumption in the future. Fisher was pretty much interested in measuring inflation and hence was a leading supporter of inflation-indexed bonds. For measuring the inflation, he had created an inflation index and carefully published its value (Geanakoplos, 2005). For understanding the assumptions of Fisher Theory or the later arguments towards the position of inflation expectation, three behavioral patterns will have to be used: complete illusion, adaptive lag, and rational expectations.
These patterns show consistency with the deviation of the market and real interests during the changes of the price level. They will reflect the various ways of adjustment that they make to bring the deviation that should occur. A complete understanding of these patterns will lead to the support of the hypothesis that there is a positive link between the rate of interest and nominal interest rate (University of Detroit Mercy, 2006). This behavior pattern is reflected during the periods of price stability which people were habituated during 1952-1964.
During the period, the entrepreneurs used to enjoy no profit at all. The people were susceptible towards inflation effect. As inflation started during the 60s, the people showed little concern. According to their mindset, the observation in the market was real for them. With the first oil shock in 1973, they began to feel the pressure of decreasing income as real rates decreased (Thaler, 1997). With the lag in 1973, people began to adjust their expectations and began to approach the inflation premiums in the form of higher rate of interest.
They were approaching to compensate for the loss that they have incurred due to capital investment. It should be noted here that in the behavioral pat behavioral plate illusion, all the adjustments were done by the real interest rates.
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