The Fisher equation and short-term interest rates
Date
1994
Authors
Thatcher, Andreas
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Abstract
Over the past twenty years real interest rates, measured ex-post, have varied considerably. Recent economic theory has isolated the role of expectations as a factor in decision and policymaking processes. The relationship between inflation expectations and real interest rates was formalized by Irving Fisher, who defined nominal interest rates in terms of two unobservable variables: real interest rates and inflation expectations. The question which remains unresolved is the relationship between the two unobserved variables. The Fisher hypothesis claims that since the real interest rate is constant and unaffected by inflation expectations, the nominal rate reflects completely changes in inflation expectations.
That the Fisher hypothesis is unresolved is mostly due to the difficulty in measuring the variables, as the measurement defines the relationship, and on the model used to test the relationship. Recent economic literature has produced a range of conflicting values.
In order to pursue this question in a Canadian setting, a reduced-form model of the nominal interest rates is developed, incorporating the models of loanable funds and liquidity preference, and substituted into the Fisher equation. The model differs from previous studies, to which it is compared, because it accounts for international capital flows, and corrects for autocorrelation. The model sets nominal after-tax interest rates dependent on inflation expectations, inflation uncertainty, government deficits, economic activity, unexpected money supply changes and international capital flows.
A number of conclusion were drawn from the results. First, the role of unexpected money supply changes and economic output were significant. Second, like government deficits, inflation uncertainty was rejected, a conclusion consistent with most previous studies. Third, international capital movements proved to be a strong influence. Lastly, rejection of the Fisher hypothesis indicates that inflation expectations inversely affect the real interest rate in the short term. This is primarily due to a real balance effect which causes less non-interest bearing assets to be held (the Mundell effect), and to price setting by the Bank of Canada (the "Inverted" Fisher effect).