Interest Rates

The Fisher Effect is an economy theory that describes the relationship between inflation and real and nominal interest rates. It asserts that the real interest rate equals the nominal interest rate minus the expected inflation rate. So, real interest rates go down as inflation goes up, unless the nominal interest rate goes up at the same rate as inflation.

The nominal interest rate is the interest rate before accounting for inflation. The federal funds rate, the interest rate set by the Federal Reserve, is the short-term nominal interest rate. It is the basis for other interest rates charged by banks and financial institutions.

The expectations theory is used to predict future short-term interest rates based on current long-term interest rates. The theory asserts that an investor earns the same amount of interest by investing in two consecutive one-year bond investments as investing in one two-year bond. It also says that long-term rates can be used to indicate the rates of short-term bonds in the future.

The prime rate is the interest rate that commercial banks charge the most creditworthy corporate customers. The federal funds overnight rate is used as the basis for the prime rate, and the prime serves as the starting point for most other interest rates such as mortgages and personal loans.

Overnight rates are the interest rates that financial institutions lend funds to each other at the end of the day in the overnight market. These lending activities help ensure the maintenance of federally-mandated reserve requirements. Overnight rates are predictors of short-term interest rate movement in the economy and can have a domino effect on economic indicators such as employment and inflation.

A dove is an economic policy advisor who promotes monetary policies that involve low-interest rates. These advisors tend to support low-interest rates and an expansionary monetary policy because they value indicators like low unemployment over keeping inflation low.