The real interest rate adjusts the nominal interest rate (12%) to the rate of inflation and equals the nominal rate minus the inflation rate. The real interest rate indicates the change in purchasing power experienced by a depositors. In this case, banks and depositors anticipate an inflation rate of 7%, so the expected real interest rate is calculated as follows:

If inflation rises unexpectedly, in the short run banks and depositors will not set the nominal interest rate to reflect the increase in the inflation rate. The actual real interest rate will, therefore, turn out to be different from the expected real interest rate. In this case, inflation rises unexpectedly from 7% to 10%.

The unexpected increase in inflation causes the actual real interest rate to fall below the expected real interest rate in the short run. While banks benefit from paying a lower real interest rate, depositors, who now receive a smaller-than-expected increase in purchasing power in return for the funds they deposit with the banks.

The Fisher effect describes the long-run behavior of nominal interest rates and inflation based on the principle of monetary neutrality—the notion that monetary changes do not affect real variables in the long run. In the long run, banks and depositors will agree to a new nominal interest rate as their expectations of inflation adjust.

In the long run, the nominal interest rate will adjust to the sum of the old nominal interest rate (12%) and the change in the inflation rate (10%−7%=3%$\mathrm{10\%}-\mathrm{7\%}=\mathrm{3\%}$):

In other words, in the long run, the 3-percentage-point increase in inflation will be reflected in a 3-percentage-point increase in the nominal interest rate. The long-run real interest rate is thus reestablished. In accordance with the principle of monetary neutrality, the long-run real interest rate is not affected by the increase in the money supply and the inflation that accompanies it.