The Global Factor in Neutral Policy Rates: Some Implications for Exchange Rates, Monetary Policy, and Policy Coordination
2
Citation
0
Reference
10
Related Paper
Citation Trend
Abstract:
This paper highlights some of the theoretical and practical implications for monetary policy and exchange rates that derive specifically from the presence of a global general equilibrium factor embedded in neutral real policy rates in open economies. Using a standard two country DSGE model, we derive a structural decomposition in which the nominal exchange rate is a function of the expected present value of future neutral real interest rate differentials plus a business cycle factor and a PPP factor. Country specific “r*” shocks in general require optimal monetary policy to pass these through to the policy rate, but such shocks will also have exchange rate implications, with an expected decline in the path of the real neutral policy rate reflected in a depreciation of the nominal exchange rate. We document a novel empirical regularity between the equilibrium error in the VECM representation of the empirical Holston Laubach Williams (2017) four country r* model and the value of the nominal trade weighted dollar. In fact, the correlation between the dollar and the 12 quarter lag of the HLW equilibrium error is estimated to be 0.7. Global shocks to r* under optimal policy require no exchange rate adjustment because passing though r* shocks to policy rates ‘does all the work’ of maintaining global equilibrium. We also study a richer model with international spill overs so that in theory there can be gains to international policy cooperation. In this richer model we obtain a similar decomposition for the nominal exchange rate, but with the added feature that r* in each country is a function global productivity and business cycle factors even if these factors are themselves independent across countries. We argue that in practice, there could well be significant costs to central bank communication and credibility under a regime of formal policy cooperation, but that gains to policy coordination could be substantial given that r*’s are unobserved but are correlated across countries.Keywords:
Depreciation (economics)
International Fisher effect
Liberian dollar
Taylor rule
International Fisher effect
Deflation
Fisher equation
Cite
Citations (2)
This paper investigates the stationary characteristics of computed real interest rates with nominal interest rates and inflation for 22 OECD countries. Using quarterly data over the 2000 – 2010 period, LM unit root test is employed which endogenously determines up to two structural breaks in level and trend. The empirical findings suggest a combination of stationary and nonstationary results for real interest rates, nominal interest rates and inflation. Besides, the internal stationarity or nonstationary interactions of real and nominal interest rates are investigated by inflation. The results indicate that stationary nominal interest rates and inflation cause stationary real interest rates. At the same time nonstationary nominal interest rates and inflation could cause a stationary or nonstationary real interest rate with respect to cointegration. Stationary nominal interest rate and nonstationary real interest rate cause to nonstationary real interest rate while nonstationary nominal interest rate and stationary inflation could cause stationary or nonstationary real interest rate.
International Fisher effect
Unit root test
Cite
Citations (2)
The Fisher effect postulated that real interest rate is constant, and that nominal interest rate and expected inflation move one-for-one together. This paper employs Johansen’s method to investigate for the existence of a long-run Fisher effect in the Singapore economy over the period 1976 to 2006, and finds evidence of a positive relationship between nominal interest rate and inflation rate while rejecting the notion of a full Fisher Effect. The dynamic relationship between nominal interest rate and inflation rate is also examined from the error-correction models derived, and the analysis is extended to investigate the impulse response functions of inflation and nominal interest rates where we discover the presence of the Price Puzzle in the Singapore market.
International Fisher effect
Fisher equation
Impulse response
Cite
Citations (2)
The economic turmoil of the 1970's resulted in record postwar increases in inflation, unemployment, and nominal interest rates. Yet, it was declines that were hardest to explain. The average real value of a share of common stock plummeted. Productivity growth evaporated. Real interest rates, measured as the spread between nominal interest rates and the inflation rate, turned negative (see Table 1). Over the past decade, an explosion has occurred in the amount of attention paid to the relationship between nominal and thus real interest rates and expected inflation rates. A good deal of this effort has been directed toward empirical analysis of the Fisher neutrality hypothesis that nominal rates respond one for one with expected inflation rates. Most empirical tests of the Fisher hypothesis have been bivariate; interest rates were regressed on a constant and on actual or expected inflation measures. Estimates of the impact of inflation on interest rates in these and even in extended models are often significantly below one, are often statistically imprecise, and tend to be unstable over time.' The middle column of Table I reflects this. The coefficient of inflation on nominal interest rates there drops from 0.78 to 0.59 in the latter 1970's. Another branch of work on nominal interest rates has concentrated on the institutional impediments to the Fisher hypothesis. Robert Mundell and James Tobin demonstrate that nominal rates change by a smaller amount than the expected inflation rate does when a real balance effect exists and money pays no interest. Michael Darby and Martin Feldstein, on the other hand, argue that nominal rates should exhibit a greater-thanunity response to expected inflation due to the nature of U.S. income tax laws.2 Here I estimate the relation between interest rates, expected inflation, and real forces. Such estimates are required for evaluating the effects of inflation on saving, investment, the distribution of income, and the redistribution of wealth. To generate estimates of the net impact of these various factors on interest rates and to avoid the identification and simultaneity problems masked, but not often remedied, by instrumental variables techniques, I employ only exogenous regressors. To buttress the argument, I examine the individual links in the chain which are summarized in the reduced form. The novel aspect of the model presented in Section I is its addition of aggregate supply shocks to the determination of interest rates. I trace the reduction in the supply of complementary factor inputs in the 1970's to a decline in the demand for capital and therefore in real interest rates. The inclusion of this supply force along with expected inflation allows one to distinguish between two, offsetting effects on interest rates: the depressing effect on real rates through lower investment demand and the elevating effect on nominal rates of higher expected inflation. The results in Section II not only strongly support the economic and statistical importance of supply shocks on real interest rates, but also resolve some longstanding interest rate puzzles. Allowing for the impact of factor supply produces a significant estimated response to expected inflation for a sample that ends prior to late 1960's. The magnitude *Assistant professor, School of Business Administration, University of California-Berkeley. I would like to thank George Akerlof, Robert J. Gordon, Robert A. Meyer, Joe Peek, Janet Yellen, the members of the Economic Analysis and Policy seminar at Berkeley, participants at the NBER Conference on Inflation and Financial Markets, and anonymous referees for helpful comments. Data Resources supplied data and computational services. Financial support was provided by the Berkeley Program in Finance and NSF grant SES8109093. Linda Pacheco supplied able research assistance. Errors of omission or commission are my responsibility. 'See William Gibson, David Pyle, John Carlson, and Thomas Cargill and Robert Meyer. 2Maurice Levi and John Makin derive the reducedform effect of expected inflation on nominal interest rates as a function of the structural parameters.
International Fisher effect
Fisher equation
Classical dichotomy
Cite
Citations (112)
ABSTRACT To Irving Fisher, the market agents in capital markets respond to the changes in the real, rather than, the nominal interest rate. Since any rise in the rate of inflation lowers the real interest rate, a fall in the real interest rate must be compensated for by an equal rise in the (market) interest rate. As such, the interest rate must rise (fall) by the amount of the rise (fall) in the rate of inflation. This one-to-one correspondence of the interest rate with the rate of inflation is termed as the Fisher effect, which has been tested several times by several researchers, in different frameworks, with different econometric techniques, and on cross-sectional, as well as, time series data. Our study takes a different approach. Instead of asking whether a change in inflation rate affects the nominal interest rate one-for-one, we ask whether the exchange rate between two currencies is affected by the change in interest rates in the two countries if the Fisher effect is for real. In our study, thus, the validity of Fisher effect is tested while examining the relationship between the exchange rate and the interest rates in two countries. We tested our model on the data for exchange rate of Indian currency with the U.S. dollar and on the interest rates in India and the United States for the years 1961-2014 and found no evidence of the Fisher effect. Keywords purchasing power parity, exchange rate, interest rate, stationarity
International Fisher effect
Fisher equation
Covered interest arbitrage
Cite
Citations (0)
Advances in the development of Dynamic Stochastic General Equilibrium (DSGE) models towards medium-scale structural frameworks with satisfying data coherence have considerably enhanced the range of analytical tools well-suited for monetary policy evaluation. The present paper intends to make a step forward in this direction: using US data over the Volker-Greenspan sample, we perform a DGSE-VAR estimation of a medium-scale DSGE model very close to Smets and Wouters [2007] specification, where monetary policy is set according to a Ramsey-planner decision problem. Those results are then contrasted with the DSGE-VAR estimation of the same model featuring a Taylortype interest rate rule. Our results show in particular that the restrictions imposed by the welfare-maximizing Ramsey policy deteriorates the empirical performance with respect to a Taylor rule specification. However, it turns out that, along selected conditional dimensions, and notably for productivity shocks, the Ramsey policy and the estimated Taylor rule deliver similar economic propagation.
Taylor rule
New Keynesian economics
Cite
Citations (29)
Relying on Fisher Effect, some scholars suggest that nominal interest rates are the ideal indicator of inflation. However others advance their doubts and hold that with the change in inflation the real interest rates are not fixed, therefore the change in inflation is not necessarily reflected correspondingly in the change in nominal interest rates. The author holds that even if the relationship between nominal interest rates and inflation is not fixed, as long as the two series are cointegrated, the long-term equilibrium relationship between the two will exist and the change in inflation will be reflected proportionally in the change in nominal interest rates and the nominal interest rates are still the ideal indicator of inflation. The study shows that the nominal interest rates are fit to be the inflation indicator of our country.
International Fisher effect
Fisher equation
Cite
Citations (0)
Do nominal rates of interest change with inflation expectations, changes in expected real rates of interest or both? By 1996, nominal interest rates, inflation, and money supply growth in the United States and six industrial countries had significantly retreated from peak levels in the early 1980s. In explaining the rise of nominal yields, in these countries, up to the 1980s, this paper finds evidence for both higher inflation and higher real rates of interest. In contrast with the idea that variations in nominal yields are principally the product of variations in expected rates of inflation, this paper finds evidence that real rates of interest were non-constant in all countries. After 1981, lower rates of inflation in all countries were eventually manifested, sooner or later, in lower rates of interest. Simple tests of significance provide more support for the inflation-interest rate connection than do cointegration tests. While simple tests of significance suggest evidence that changes in real rates of interest contributed to changes in nominal yields, tests of cointegration provide little or no support for this position.
International Fisher effect
Rest (music)
Cite
Citations (0)
Taylor rule
New Keynesian economics
Bayes estimator
Cite
Citations (60)
The Fisher Effect postulated that real interest rate is constant, and that nominal interest rate and expected inflation move one-for-one together. This paper employs Johansen's method to investigate for the existence of a long-run Fisher effect in the Singapore economy over the period 1976 to 2006, and finds evidence of a positive relationship between nominal interest rate and inflation rate while rejecting the notion of a full Fisher Effect. The dynamic relationship between nominal interest rate and inflation rate is also examined from the error-correction models derived, and the analysis is extended to investigate the impulse response functions of inflation and nominal interest rates where we discover the presence of the Price Puzzle in the Singapore market.
International Fisher effect
Fisher equation
Impulse response
Cite
Citations (2)