Jun 1, 2008 Report No：08-04
DEVOLUTION OF THE FISHER EQUATION:Rational Appreciation to Money Illusion
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 Fisher‟s theory of “money illusion.” [JEL: E40, B00, B31]
||Fisher equation, Fisher hypothesis, Fisher effect, money illusion, nominal interest rate, purchasing power of money, value of money.