Long-Run Relatinship between Interest Rates and Inflation : An Error Correction Model

The extent to which movements in nominal interest rates change with anticipated inflation has been keenly researched ever since Fisher (1930) first pointed out that efficient capital markets should compensate for changes in the purchasing power of money. In the Indian context, this relationship was not given much focus until the beginning of 1990s due to the administered interest rate mechanism. Since the beginning of economic reforms and the liberalization of capital market, the interest rates were allowed to float, except the Bank Rate and the interest rate on savings deposits and the question of determining the interest rates became a big issue. Hence, this study examines the short-run and long run comovements of interest rates and inflation using cointegration analysis and error correction model. The results show that inflation causes 91-day Treasury bill yield and MIBOR indicating that the interest rates are now more market determined and there is evidence of Fisher's hypothesis