The Long Run Relationship between Nominal Interest Rates and Inflation : The Fisher Equation Revisited

The empirical literature examining the Fisher equation has produced results that are generally inconsistent with the simple textbook representation. Much of this evidence is obtained from statistical analysis that fails to recognize that the nominal interest rate and expected inflation may be modeled as distinct nonstationary series that share a common stochastic trend. Using a fully efficient estimator of theimplied cointegration vector we find evidence of a postwar Fisher relation that is consistent with the standard textbook representation even when taxes on interest income are taken into account. Dynamic analysis based on this long- run relation identifies the common source of the instability (nonstationarity) in the system of nominal interest rates and inflation as the accumulation of inflation innovations. The dynamic response of the system to these shocks is examined by distinguishing the shock that leaves a permanent imprint on the system from the shock that has only a transitory effect