the real interest rate are the propensity of households to save and the expected productivity (or we could say profitability) of in- vestment in physical capital, the real rate can be affected as well by government fiscal and monetary policies.     The Equilibrium Nominal Rate of Interest   Weve seen that the real rate of return on an asset is approximately equal to the nominal rate minus the inflation rate. Because investors should be concerned with their real re- turns-the increase in their purchasing power-we would expect that as the inflation rate increases, investors will demand higher nominal rates of return on their investments. This higher rate is necessary to maintain the expected real return offered by an investment. Irving Fisher (1930) argued that the nominal rate ought to increase one for one with in- creases in the expected inflation rate. If we use the notation E(i) to denote the current ex- pectation of the inflation rate that will prevail over the coming period, then we can state the so-called Fisher equation formally as   R r E(i)   This relationship has been debated and empirically investigated. The equation implies that if real rates are reasonably stable, then increases in nominal rates ought to predict higher inflation rates. The results are mixed; although the data do not strongly support this rela- tionship, nominal interest rates seem to predict inflation as well as alternative methods, in part because we are unable to forecast inflation well with any method. One reason it is difficult to determine the empirical validity of the Fisher hypothesis that changes in nominal rates predict changes in future inflation rates is that the real rate also I. Introduction 5. History of Interest Rates and Risk Premiums The McGraw−Hill Companies, 2001           CHAPTER 5 History of Interest Rates and Risk Premiums 135     Figure 5.2 Interest and 16 inflation rates, 14 1954-1999. 12   10