Hundreds of individuals have impacted economics throughout its vast history. Only a handful of these individuals are household names recognized with economics today. However, many lessor known economists have made lasting impressions, often making attributions to the theories we know today. One of these individuals who influenced economics in this way was Irving Fisher. Irving Fisher was a very unique and brilliant man. He attended Yale University where he studied mathematics. He later used this background and applied it to economics, earning a PhD in economics, the first from Yale University.
His study of mathematics played a crucial role in how his theories evolved. Almost all of his work involves mathematical computations to express the theories he devised. Fisher’s theories were revolutionary in the time period as a result, but his theories and legacy was tarnished due to one public statement in his career. He publicly announced right before the stock market crash of 1929 that the stock market had reached a “permanent plateau” and improvements were imminent. However, we know this never happened and he paid for it in both his career and his financial situation.
It wasn’t until years later that people began to look back and realize Irving Fisher still had innovative theories and ideas. One of these theories that Fisher gave to the world of economics was his theory of interest. His contributions first appeared in The Nature of Capital and Income (1906), next The Rate of Interest (1907) and later the revised version The Theory of Interest (1930). These works drew upon two prior individuals, John Rae and Eugen von Bohm-Bawerk, in developing them.
Fisher believed the works of Rae and Bawerk didn’t provide a complete explanation of how the rate of interest is determined. Therefore, Fisher expanded and clarified what both of these economists tried to do. Fisher did this by introducing his two period diagram which showed how interest rates were determined. Irving Fisher’s diagram used the impatience rate (the marginal rate of time preference for immediate income, represented by the slope of the indifference curve) and the investment opportunity rate (the expected rate of return, represented by the slope for the budget constraint) as shown below.
Fisher explains that when the equilibrium between these two factors exists, the interest rate is thus determined. This theory of interest is still how we determine interest, even after about 100 years have passed since its introduction. Clearly this theory was well ahead of its time. In addition, Fisher stated that the real rate of interest generated by the interaction between the impatient rate and opportunity rate was not always the nominal rate due to inflation. He stated that the nominal rate minus the inflation rate equals the real rate that you are expected to earn.
This relationship is known as the Fisher Effect and is a major principle in economics and finance in everyday calculations. From these same works Fisher also developed the concept of the expenditure tax. The expenditure tax is different from the income tax because one is only taxed on income minus one’s net savings, rather than one’s whole income. Fisher believed the income tax induced bias against saving and created double taxation on both the income you earned initially and the income you earn from investing or saving money.
Irving Fisher also made major contributions in to monetary economics. He expanded the old quantity theory of money by introducing the equation of exchange (MV = PT) in The Purchasing Power of Money. This new modified quantity theory of money, demonstrated that the level of prices depends exclusively on five factors: the volume of money in circulation (M), the velocity of circulation (V), the volume of bank deposits subject to checking (M`), its velocity (V`) and volume of trade (PT where P is the average level of prices and T is the quantity of goods and services transacted or sold).
It can be written as MV +M`V` = PT. This theory showed what happens to the price level when the amount of money in circulation changes. Even though Irving Fisher only expanded and included two extra variables in the Equation of Exchange, he is usually given credit for it instead of Simon Newcomb, who came up with the original theory (MV = PT). In developing the Equation of Exchange, Irving Fisher also began working on index numbers. Before his time, the Laspeyres index and the Paasche index had been introduced. These two indices were very good at measuring changes n the cost of living from different points in time, but had some major faults. They either understated or overstated inflation. Fisher’s new price index, known as the “ideal” index, is simply the geometric mean of the Laspeyres index and Paasche formulas. However, he demonstrated that this index minimized the previous imperfections but still didn’t solve them completely. Even though imperfections were present in Fisher’s model, modern day economists believe this is inevitable, and therefore still use Fisher’s ideal index as a basis of their index number system.
In addition, based on his statistical calculations he demonstrated there was a negative correlation between the rate of inflation and the unemployment rate. This relationship is now known as the Phillips Curve, even though A. W. Phillips was not the first to present this idea. As you can see, Irving Fisher contributed to the advancement of economics in a wide range of topics ranging from income and capital theory to monetary policies. To this day Fisher is widely recognized for developing many tools and theories we use.
Some of these include the distributed lag regression, life cycle saving theory, the Phillips curve, the case for taxing consumption rather than income and the modern quantity theory of money. Some may remember Fisher as having made a substantial misstep in his career as a consequence of his claim right before the stock market crash of 1929. But this can easily be disregarded, as he made many significant contributions to economics. As a result, Fisher should be viewed as one of the greatest economists in history.