Fisher Equation Revisited – Nominal Rate of Return, Real Rate of Return, Inflation, and Capital Maintenance

Abstract

We evaluate the well-known Fisher Equation in the context of accounting income with a focus on its implicit assumptions regarding capital maintenance. Our findings indicate that the Fisher Equation does not allow for a consistent conversion from nominal to real terms, given that it modifies the capital maintenance assumption inherent in nominal income. As a consequence, periodic income figures, and the resulting possible consumption patterns, are not equivalent in both standards. We find this inacceptable when dealing with accounting income, since the definition of income is modified through the conversion and, thus, the intention of standard setters. To resolve this issue we formulate a generalized version of the Fisher Equation that captures capital maintenance explicitly and allows for a consistent conversion. The Generalized Fisher Equation provides a parsimonious framework to convert nominal [real] terms to real [nominal] terms without tempering with the underlying capital maintenance assumptions.