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

Revisited
Author(s): William J. Crowder and Dennis L. Hoffman
Source: Journal of Money, Credit and Banking, Vol. 28, No. 1 (Feb., 1996), pp. 102-118
Published by: Ohio State University Press
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 WILLIAM J. CROWDER
DENNIS L. HOFFMAN

The Long-RunRelationshipbetween Nominal

InterestRates and Inflation:
The Fisher EquationRevisited

THEPASTSEVERAL DECADES have seen numerousempirical

studies of the Fisher equation. This well-known hypothesis, introducedby Irving
Fisher (1930), maintainsthatthe nominalinterestrateis the sum of the constantreal
rate and expected decline in the purchasingpower of money. Startingwith Fisher
and extending to the present (for example, Mishkin 1992 and Evans and Lewis
1995), this seemingly simple and intuitive hypothesis has found limited empirical
support.Typically,the estimatedcoefficientson expected inflationare substantially
less thanthe hypothesizedvalue of one, excluding tax considerations.When tax ef-
fects (see Darby 1975) are considered,the hypothesizedcoefficientshould be in the
range of 1.3 to 1.5 since agents have incentives to bid nominalinterestrates to lev-
els thatallow nominalinterestratemovementsto mirrormovementsin "tax-adjusted"
estimates of the futurecourse of inflation.l Estimatesbelow unity imply substantial
adjustmentin real interestrates in responseto changes in expected inflation.
A numberof papersaugmentthe basic Fisher equationwith explanationsof real
interestrate movements that presumablyreconcile these findings. Levi and Makin
(1978), Melvin (1982), and Peek and Wilcox (1983) demonstratethat Mundell-
Tobineffects (the decline in the marginalproductof capital due to the real balance

An earlierversion of this papercirculatedunderthe title "Is There a Long-RunRelationshipbetween

Nominal InterestRates and Inflation?The Fisher EquationRevisited."The authorshave benefittedfrom
the comments of Art Blakemore, Tim Bollerslev, Clive Granger,Karen Lewis, Mike Melvin, Robert
Rasche, Don Schlagenhauf,several anonymousreferees, and the seminarparticipantsat SouthernMeth-
odist University.Crowderacknowledgesa UTA College of Business SummerResearchGrant.Hoffman
wishes to acknowledge the supportof the summerresearchprogramat Arizona State University.
1. See Summers(1983) for additionaldiscussion of tax effects.
WILLIAMJ. CROWDERis assistant professor of economics, University of Texas at Ar-
lington. DENNISL. HOFFMANis professor of economics at ArizonaState University.
Journal of Money, Credit, and Banking, Vol. 28, No. 1 (February
1996)
Copyright1996by TheOhioStateUniversityPress

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 WILLIAMJ. CROWDERAND DENNIS L. HOFFMAN : 103

response to inflation) may have considerablesignificance. However, Lucas (1980)

and Fried and Howitt (1983) contend that in models characterizedby super-
neutrality,inflation will not affect real rates in this mannerover the long run. If
output is supply determined,as characterizedby most long-runexplanationsof the
macro economy, short-runadjustmentssuch as Mundell-Tobineffects should not
dominatethe data.
Several recent empirical studies recognize that valid tests of the Fisher relation
may require considerationof the time series propertiesof the data. These include
papers by Rose (1988), Mishkin (1992), and Evans and Lewis (1995). Rose an-
alyzes the time series propertiesof the variablesthatconstitutethe Fisherparadigm
and concludes that interestratespossess a unit root in their autoregressiverepresen-
tation, but inflationdoes not. If these propertiesdo characterizethe data, a regres-
sion of interestrates on inflationis necessarily spurious(see Newbold and Davies
1978) because it attemptsto link variablesthat maintaindifferentordersof integra-
tion. In this case the real interestrate is a nonstationaryseries and the textbookrep-
resentationof the Fisher relation may be rejectedout of hand. Rose's conclusions
must be viewed carefully since the statisticalinferencedrawnfrom his tests does not
account for the small sample distributionsof standardunit root tests in the presence
of moving averageerrorsthatmay characterizeU.S. inflation.Moreover,it is wide-
ly recognized that conventional univariateunit root tests have a difficulttime dis-
tinguishing unit and near unit root processes and may not be able to provide a
definitive test of the proposition.
Mishkin (1992) takes the nonstationarityof inflationand nominalinterestratesas
a maintainedhypothesis and applies the Engle and Granger(1987) methodologyto
test for common stochastictrends.The simple Fisherrelationpredictsthe two series
share a common stochastic trend and a long-run unitary (ignoring tax consider-
ations) response of nominal interest rates to movements in the expected inflation
rate. While noteworthy,Mishkin's analysis does not provide particularlysharpsta-
tistical inferencebecause his estimateof the relationbetween inflationand nominal
interestrates is very imprecise.2Mishkin'sanalysis serves as an importantfirststep,
but it would be useful to obtain bettermeasuresof the long-runrelation.
Evans and Lewis (1995), henceforth EL, also observe cointegrationbetween
nominal interestrates and inflationin a sample of postwardataand apply the DOLS
estimator(a least squaresprojectionof nominalinterestrateson inflationin a model
augmentedwith lead and lag changes in inflation)of Stock and Watson(1993) to
estimatethe long-runresponseof nominalinterestrateswith respectto inflation.EL
ascribe their observed less-than-unityexpected inflationcoefficientsto the "chang-
ing dynamics of inflation"over the sample. They bolstertheircase with Monte Car-
lo evidence that demonstratesthat a downward bias in the estimated long-run
coefficient will occur if inflationis characterizedby a Markovswitchingprocess and
there is no attemptto account for this switch in the DOLS specification. EL con-

2. Mishkin's estimates are insignificantlydifferentfrom either zero or the implied after-taxvalues of

1.3 to 1.5.

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104 : MONEY, CREDIT,AND BANKING

clude that the Fisher hypothesis is generally consistent with postwar data once we
recognize that agents have been forced to form expectationsfrom an inflationpro-
cess that has undergone several structuralchanges in the postwar period and that
their DOLS results simply suffer from small sample bias. EL do not attemptto ex-
plain why DOLS models specifiedby projectinginterestrateson inflation(as a text-
book Fisher equation would suggest) and the "Fama specification"that projects
inflation on interest rates yield vastly differentconclusions about the relationship
between inflationand interestrates.3
This paper extends the empiricalliteratureon the Fisher equationin several new
directions. Following the lead of Mishkinand EL, we recognize thatthe persistence
in nominal interestrates and inflationcan be modeled underthe unit root hypothe-
sis. We apply a fully efficientestimator(Johansen1988) thatseparatesestimationof
the long-runequilibriumrelationshipfrom nuisanceparametersthatcharacterizethe
short-rundynamics. In contrastto EL, the estimateswe obtain are consistentwith a
long-runFisherrelationwhere nominalinterestratesfully respondto movementsin
inflationeven afterallowing for the changes in marginaltax ratesthathave occurred
over the sample.4 Unlike the DOLS specification,the results do not depend on the
arbitrarychoice of the variable on which to normalizeprior to estimation. More-
over, we reach this conclusion without introducingany changes in the dynamicsof
the inflation process.5 The results we obtain are robust to a numberof sensitivity
exercises, including applicationto the Mishkin and EL data sets. The advantageof
the maximumlikelihood approachin an inflation/interestrate applicationis clearly
illustratedin a series of Monte Carlo experimentsthat reveal the small sample bias
that prevails in OLS and even DOLS in situationswhere the DGP for inflationis an
integratedmoving averageprocess. This bias is observedwithoutresortingto exper-
iments that contain any distinct shifts or breaksin the dynamicsof the inflationpro-
cess. On the other hand, the small sample distributionof the maximumlikelihood
estimatoris quite differentand may presenta more attractiveavenue for delivering
accurateestimatesof this particularlong-runrelationship.This suggests that, due to
the integratedmoving average natureof the inflationprocess, choice of estimator
may have importantimplications for testing the validity of the Fisher equation.
Second, we incorporatetime series data on the marginaltax rates on ordinaryin-
come in the U.S. that allows a direct test of the marginaltax rate (Darby) effect.
Third, we test for and identify, using methods recently developed by Gonzalo and
Granger(1991), King et al. (1991), and Warne(1991), the mechanismresponsible
for the nonstationarybehaviorof the system. This reveals the dynamic behaviorof
nominal interestrates and inflationin a bivariateVECM characterizedby the long-
run Fisher equilibrium.Examinationof the vector errorcorrectionmodel (VECM)

3. EL's "Fama"specificationdelivers estimates consistentwith the predictionsof the after-taxFisher

relationwhile the DOLS model based on the projectionof interestrates on inflationdoes not.
4. EL's experimentswith marginaltax rates assumeda fixed rate of 0.3 throughoutthe sample.
5. We do not claim that there were no switches in the inflationprocess as identifiedby EL, but our
findings suggest that the small sample distributionof their chosen DOLS estimatorexhibits significant
downwardbias even in experimentsdesigned in the absence of possible breaksin the inflationprocess.

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 WILLIAMJ. CROWDERAND DENNIS L. HOFFMAN : 105

reveals a specific "causal"orderingthat suggests inflationhas predictivecontentfor

the future course of interest rates. This is opposite to the conclusions reached by
Fama (1975). The response of after-taxreal rates to nominal or inflationshocks is
also measuredin the analysis. The observed relationhelps to reconcile the widely
documentedpersistencein real interestrates.
This paperis organizedas follows: section 1 presentsthe generalizedFisherequa-
tion that is consistent with a representativeagent framework.Section 2 containsthe
estimationand related sensitivity analysis includingthe small sample experiments.
Section 3 presentsthe dynamics and section 4 concludes.

1. THE FISHERRELATION

The simple asset-pricingmodel attributedto Lucas (1978) (see Sargent 1987, p.

107) yields a generalizedform of the Fisherequationthat is consistentwith rational
expectations. The model economy is populatedby a representativehousehold that
maximizes periodic utility subjectto an intertemporalbudgetconstraint.The assets
tradedin this economy consist of a one-periodnominaldefault-freebond that pays
in currency and a one-period risk-free bond that pays in the single consumption
good. Finally, the returnto the nominalbond is taxed at the rate ,. The first-order
conditions yield an equilibriumcondition for the expected real returnin terms of
marginalutility of consumption.Assuming that utility is of the hyperbolicabsolute
risk aversion (HARA) class and that expected consumptiongrowth and expected
inflation are jointly log normally distributed,the generalized form of the Fisher
equationcan be rewrittenas in equation(1):

i,(l-,) = r, + E,/\p,+l + O.SVar,/\p,+l-wCov,(/\c,+l, /\P.+1) (1)

where P, is the price level in periodt, C, is the level of consumptionin periodt, and
E, is the expectationsoperatorconditionalon informationavailablein periodt. Low-
ercase letters denote naturallogs of prices and consumptionand i, and r, are the
continuouslycompoundednominal and real rates of interestrespectively.The term
y representsthe coefficient of relative risk aversion.6
Equation( 1) statesthatthe "after-tax"nominalinterestrateis positively relatedto
the real rate and expected inflationas in Fisher's original theory.The expected de-
cline in the purchasingpower of money is capturedby the expectedinflationplus the
conditionalvarianceof inflation. The conditionalcovariancebetween consumption
growth and inflation can be interpretedas a risk premium. When expected future
consumptiongrowth is low (implying the marginalutility of consumptionis high)
and expected inflationis high (implying a decline in the purchasingpower of mon-
ey), a negative conditional covariance results. The nominal bond provides a poor
hedge against unanticipatedconsumptionchanges and householdsrequirea higher

6. See Shome, Smith, and Pinkerton(1988) and Evans and Wachtel(1990) for a morecomplete inter-
pretationof equation(1).

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106 : MONEY, CREDIT,AND BANKING

nominal yield to compensate. When expected consumptiongrowth is low and the

expected purchasingpower of money is high (low expectedinflation),then the nom-
inal bond is an effective vehicle for smoothing consumptionimplying a lower re-
quired nominal yield. The evidence given by Shome, Smith, and Pinkerton(1988)
implies that the effects of the risk premium on the "Fisher effect" estimates are
inconsequential.7However, rejectionsof the implicationsof the textbookFisherre-
lation may suggest that these factors are indeed important.The tax-adjusted"ob-
servable"Fisher equationis given in equation(2):

i,= Pt(ll_ P) ( + u,+ (2)

where i, is the nominalshort-terminterestratefromperiodt to t + 1, /\P,+ 1is the ex

post inflationrate from t to t + 1, p is the mean of the real short-terminterestrate
from period t to t + 1 plus one-half the conditionalvarianceof inflation, 4 is the
mean of the risk premium,, is the averagemarginaltax rate, and u,+l contains all
stationarystochastic terms.8Equation(2) clearly reveals that the constantterm in a
simple relationlinking nominalinterestratesto inflationcomprisesthe tax-adjusted
real interestrate plus factors thatproxy the conditionalvarianceof inflationless the
mean of the risk premium.
Economic theory generallypredictsthat the real rate of interestfollows a station-
ary process.9 In most empiricalsettings the real rate is assumedto be stationaryor
even constant (for example, Fama 1975). If the nominal interestrate and the infla-
tion rate are both integratedof orderone, stationaryreal rates are obtainedwhen a
cointegratingvector [1, -1/(1 -)] is obtained in a bivariaterepresentationof
nominal interestrates and inflation, assumingthatthe conditionalvarianceof infla-
tion and the risk premiumare covariancestationary.In practiceit may be difficultto
ascertainthe orderof integrationof these series so evidence basedexclusively on the
presence (or absence) of unit roots may not be useful. However, our analysis sug-
gests that an accuratemeasureof the relationshipbetween the behaviorof inflation
and interest rates in the postwar period can be obtained from a specificationthat

7. Shome, Smith, and Pinkerton(1988) provideestimatesof this conditionalvarianceof inflationand

the conditional covarianceof consumptiongrowth and inflation, the risk premium,based on rolling re-
gressions. The mean conditionalvarianceof inflationbased on Livingston survey data is 0.7378 with a
standarderror of 0.4284. The mean risk premiumestimate is 0.0196 with standarderror of 0.2592.
Using time series forecasts of expected variables yields mean estimates of 0.7230 and 0.5716 for the
conditionalvarianceand covariance, respectively,with standarderrorsof 0.3906 and 0.3908. In no case
is the conditionalvarianceor risk premiumterm statisticallydifferentfrom zero.
8. The errorterm includes the rationalexpectationsforecast erroras well as the deviationsfrom the
means of the conditionalvarianceof futureinflationand the risk premiumfrom equation(2).
9. The asset-pricing model can also be used to provide predictionsof the time series propertiesof
variablesthat compose (1). Assuming the HARA functionalform for utility as above, the model predicts
that the implied time series propertiesof the real rate are the same as the time series propertiesof (ex-
pected) consumptiongrowth. Several sources have documentedthe stationarityof consumptiongrowth
rates (for example, Nelson and Plosser 1982 and Schwert 1987). Additionally,neoclassical models of
dynamic growth imply that consumptiongrowth must be constantin the steady state equilibriumimply-
ing that the real interestrate must also be constantin the steady state.

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 WILLIAMJ. CROWDERAND DENNIS L. HOFFMAN : 107

allows for the possibility that the underlyingDGPs of inflation and interest rates
maintainunit roots.
In addition to providing accuratetests of the Fisher relation, the nonstationary
specificationcan reveal the dynamicresponseof interestrates and inflationto innoD
vations that have permanentand transitoryeffects on the series. The analysis can
also isolate the long-runcausal orderingof the system by identifyinghow the non-
stationarityenters and is transmittedthroughoutthe system as well as measurethe
response of the real rate of interest to inflationinnovations. We explore these dy-
namics in the context of inflationand interestrates in section 3 below.

2. EMPIRICALANALYSIS

The data we use are the three-monthT-bill rate (FYGM3) and the implicit price
deflatorfor total consumptionexpenditures(GDC) takenfrom Citibase. Annualized
log changes in the price serve as a proxy for expected inflation.The sample is quar-
terly and runs from 1952:1 to 1991:4. Plots of the series appearin Figure 1.
The results from univariateunit root tests do not reject a unit root in the nominal
interestrate for any test statistic,even at conventionalDickey-Fullercriticalvalues.lO
The evidence of a unit root in the inflationseries is also quite compelling once we
recognize the importanceof the moving averagetermsin the process. If convention-
al Dickey-Fullercritical values are used, the null hypothesis of a unit root in the
inflationrate would be marginallyrejectedby the ADF normalizedbias test at the
5 percent level. But standardcritical values fail to account for the presence of
large moving average(MA) parametersin the univariaterepresentationof inflation
rates.ll Schwert (1987, 1989) and Pantula (1991) provide evidence of large size
distortionsin the standardDickey-Fullertests in the presence of large MA errors.
Thus, our results are consistentwith the specificationof inflationand nominalinter-
est rates as unit root processes.
If nominal interestrates and inflationare indeed driven by nonstationarities,the
textbookFisher relationimplies cointegrationor thatthey sharea common stochas-
tic trend. We test this hypothesisusing the maximumlikelihoodprocedureproposed
by Johansen(1988). Table 1 presents the results from the cointegrationtests. The
results in the top panels of Table 1 assume the marginaltax rate, , is an unknown
constantand they are based on datanot adjustedfor taxes. The model was estimated
underthreealternativespecificationsfor the deterministiccomponentsof the system
using a lag length of four in the autoregressivespecification.Model Hl(r) allows for
the presence of deterministictrendsin the data thatare also eliminatedby the coin-
tegratingvector . Model Hl*(r) allows for no deterministictrendsin the data but
does allow a nonzero mean of the equilibriumrelationship(a constantin the coin-
tegratingvector). Finally, model H°(r)restrictsthe meanof the equilibriumrelation-

10. Not presentedby availableupon request.

11. See Mankiw (1987) and Ball and Cecchetti(1990) for theoreticalexplanationsfor a unit root and
MA errorsin inflation, respectively.

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 1 7'

. I 5G -

125- ?S,'
., | , .\
, e #,

ll l l

f f % \,1 \ f \

'- 'Dl' ? ?'d''lS'\llty'f4'' " -' V t '

- 025 - INFL
TBILL - - -

-.050 1 | I TI I I I 1 } 1 1 1 1 1 1 1 1 1 } 1 } 1 T1 1 1 1 1 l 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 T 1 1 1 1 1 T1 1 1 l 1 T 1 1 1 T1 1 1 T1 T1 l 1 } 1 1 1 I

1952 1956 1960 1964 1968 1972 1976 1980 1984 1988

FIG. 1. U.S. Inflation

andThree-Month
T-BillRate,1952:1to 1991:4

TABLE 1

MULTIVARIATE UNIT ROOTANALYSIS

Trend Specificationa Alb A2b Trace r = 0c b d

Unadjusted Data
Hl(r) 0.0907 0.0301 20.09* 1.22 (0.26)
Hl*(r) 0.0909 0.0301 20.15* 1.22 (0.27)
H°(r) 0.0899 0.0051 15.88* 1.34 (0.13)
Tax Adjusted Data
H l (r) 0.0940 0.0298 20.63 * 0.84 (0.19)
Hl*(r) 0.0943 0.0298 20.69* 0.83 (0.19)
H°(r) 0.0910 0.0055 16.14* 0.97 (0.09)
NOTES:Numbers in parenthesesare asymptotic standarderrorscalculated as the square root of the LR test that ,13= O which is a X2(1)
variate. The levels VAR lag length is 4. The estimation sample is from 1952:1 to 1991:4. An asterisk(*) denotes significance at the 5
percent level.
a. Notation is consistent with Osterwald-Lenum(1992). Hl(r) refers to the VAR specificationthat allows for deterministictrendsin the
data that are eliminated by the cointegrationvector. Hl*(r) refers to the VAR specificationthat restrictsthe data to have no deterministic
trendsbut does allow the cointegrationvector to have a nonzeromean. H°(r) refersto the VAR specificationthatrestrictsthe datato have no
deterministictrends and the mean of the cointegrationvector to be zero.
b. Solutions to the Johanseneigenvalue problemgiven by IASII
- S,OSOOISOII
= O.
c. The calculated JohansenTrace test statistic.
d. Estimated Fisher effect.

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 WILLIAMJ. CROWDERAND DENNIS L. HOFFMAN : 109

ship to be zero. Since models Hl*(r) and H°(r) are nested within Hl(r), these
restrictionsare testable using the likelihood ratio proceduredescribed in Johansen
(1994).12 The calculatedtest statisticsfor Hl(l) versus Hl*(l) is 0.05, which is as-
ymptotically distributedas a X2(l) variate. Since the model Hl*(l) cannot be re-
jected, we test Hl*(l) versus H°(1). The calculatedtest statisticis 0.18 which is also
a X2(l) variate. Thus we can conclude that there is very little evidence against the
hypothesisthat p-4 = 0, thatis, thatthe ex post real interestrateplus one-half the
conditionalvarianceof inflationminus the risk premiumis zero. 13
The computedtrace statisticof 15.88 for the null of zero cointegratingvectors in
the model H°(r) is compared to the 5 percent critical value given in Table 0 of
Osterwald-Lunum(1992) which is 12.53. We can easily reject the null at this level
of significance, The computedtrace statisticof 0.68 (not shown) tests Ho: r < 1. It
is comparedto the 5 percent critical value of 3.84. We cannot reject this null and
thereforeconclude thatthe evidence suggests the presenceof one cointegrationvec-
tor in the bivariatesystem. These resultsare not sensitive to the chosen lag length in
the autoregressivespecification. A lag specificationof 4 is the shortestlag length
that removes significant serial correlationfrom the errorsin the bivariatesystem.
However, results obtained at lag lengths of 3 and 5, for purposes of comparison,
yield cointegrationvector estimates that are virtually the same as those obtained
when k = 4 while the cointegrationtest is only significantat the 10 percentlevel in
the presence of superfluouslags, that is, the k = 5 specification.
The evidence at the top half of Table 1 suggests thatthereexists one cointegrating
vector between three-monthT-bill ratesand the inflationratenext period. Thatis the
ex post real interestrateis stationaryarounda constantmean. In the long run, nomi-
nal interest rates increase by a factor of about 1.35 due to a one-unit increase in
inflation. This estimate of the Fisher effect is robust to alternativedeterministic
trend specifications. It is estimatedvery precisely and statisticallywithin the range
of parametervalues suggested by Summers.
The analysis so far has been conducted underthe implicit assumptionof a con-

12. The LR test of Hj(r)versus Hj*(r)is

_ _

P 1-Ai*
T 2, ln j
i=r+l 1 -Ai
_ _

where the Aiare the eigenvalues from the unrestrictedestimationand the Ai*are the eigenvalues from the
restrictedestimation. The LR test of HJ*versus HJ+Iis given by
_ _

r 1-Aii I

1 sJ
i=l _
1 - Ai _

where the eigenvalues are analogouslydefined.

13. This suggests an importantrole for the risk premium in explaining the observed real returnto
nominal U.S. treasurydebt. See Chan (1994) for evidence specifically relatingthe risk premiumand the
real rate of interest.

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110 : MONEY, CREDIT,AND BANKING

stant average marginaltax rate on interest income. This assumptionis clearly not
valid over our sample. To account for the effect of a time-varyingaveragemarginal
tax rate on the Fisher equilibrium, we conduct the cointegrationanalysis pursued
above using tax-adjustednominalinterestrates.14 The bottompanels of Table1 con-
tain the tax-adjustedcointegrationresults. As before, we cannotrejectHo: P-4 =
Oand find evidence of a single cointegrationvector. Moreoversthe estimatedeffect
of inflation on tax-adjustednominal interestrates is precisely estimatedand insig-
nificantlydifferentfrom unity. Results obtainedwith alternativedeterministictrend
specificationsor at lag lengths of 3 and 5 paint a similarpicture. This provides fur-
ther supportthat the after-taxeffects of changes in inflationare entirely reflectedin
nominal interestrates.
The conclusions from Table 1 differ somewhatfrom those portrayedby Mishkin
(1992) and Evans and Lewis (1995). Their results are obtained from least squares
estimators, OLS and DOLS, respectively,with data observed at a monthlyfrequen-
cy. OLS applied to our sample yields a tax-adjustedinflation coefficient of 0.53
when a constant is included in the regression and 0.84 when the potentiallysuper-
fluous constant is omitted. The DOLS (with interest rates regressed on inflation)
estimate with 4 leads/lags is 0.69 when a constantis includedin the regressionand
0.91 when the constant is omitted.ls At the same time applicationof the Johansen
maximum likelihood techniqueto the Mishkin and Evans and Lewis monthly data
yields Fisher effect estimates of-1.35 and-1.36, respectively.l6 This suggests
that the estimator choice (not data frequency or sample) may be responsible for
the observed differences. Though superconsistent,Mishkin's OLS estimates ex-
hibit small-sample bias that has been well documented(see Banjareeet al. 1986)
and statistical inference based on conventionaltests may be misleading. However,
DOLS applied by EL is asymptoticallyequivalentto maximumlikelihood and can
perform well in small samples (see Stock and Watson 1993). Conceivably the
difference may lie in relative small-sampleperformanceof the alternativeestima-
tors in the particularbivariate system comprising inflation and nominal interest
rates.
We explored the small-sample performanceof the alternativeestimators with
Monte Carlo experimentsspecifically tailored to capturethe time series processes

14. The tax data from 1952:1 to 1983:4 were taken from Barroand Sahasakul(1986). The tax data
from 1984:1 to 1991:4wereestimatedfromStatisticsofIncome:IndividualReturns(1985through 1990),
publishedby the IRS, in a mannerconsistentwith Barroand Sahasakul.The averagemarginaltax ratefor
1991 is the same as for 1990 by assumption.
15. It is also interestingto note thatthe standarderrorof the Fishereffect estimatein the DOLS speci-
fication without a constant term is 0.10 when using a Newey-Westcovariancecorrectionwith a Bartlett
window of thirty lags and 0.11 when using a window of fifteen lags. This not only implies that the tax-
adjustedFisher effect is insignificantlydifferentfrom one but that the standarderrorsfrom the Johansen
and DOLS proceduresare comparablein magnitude.
16. The Mishkin sample is from January1947 to December 1990. The Evans and Lewis sample is
from January1947 to February1987. The lag length in the levels VAR is equal to eight for both esti-
mates.

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 WILLIAMJ. CROWDERAND DENNIS L. HOFFMAN : 111

that describe the inflationand interestrates.17 We chose a conventionalframework

to capturethe underlyingDGPs of nominalinterestrates and inflation. Specifically,
inflationis modeled as an ARIMA(0, 1, 1) process and nominalinterestis modeled
as an ARIMA(1, 1, 0) process. The parameterizationof the "monthly"experiments
is based upon the data used by Evans and Lewis, while our own data serve as the
basis for parameterizationof the "quarterly"experiments.
We found considerabledownwardbias in the (normalized)cointegratingparame-
ter estimates from both OLS and DOLS in all experiments.This bias was most se-
vere for OLS, but DOLS estimates demonstrateda median bias of-0.15 and
-0.24 for the monthly and quarterlyexperiments,respectively.Most importantly,
evidence of this bias occurs in as many as 95 percent of the repetitions, without
simulating "breaks"in the dynamic process of inflation as in Evans and Lewis
(1995). In contrast, the empirical distributionof the Johansenestimator suggests
that the likelihood-basedprocedure, applied in the same setting, produces results
that do not suffer from significantbias. In a representativeexperiment,the 90 per-
cent confidence intervalfor the bias in the Johansen(JOH)estimatorcenteredabout
a medianof 0.02 is-0.04 to 0.16. The analogous90 percentconfidenceintervalfor
the bias in the DOLS estimatoris-0.46 to-0.01 with a medianof-0.15.
Our small-sampleanalysis also reveals thatthe Johansenestimatorcan generatea
small numberof large outliers as documentedby mean squarederrorcomparisons
summarizedin Stock and Watson(1993). The chance of observingthese outliers is
reduceddramaticallywith increases in sample size and correctspecificationof the
deterministiccomponentsof the data. For example, when we (correctly)restrictthe
mean of the cointegrationvector to be zero in our experiments,the frequency of
observing large outliers in our specificationis reducedto less than 1 percent.
Regardlessof sample selected, monthlyor quarterly,choice of deterministictrend
specification, or lag length used to parameterizethe autoregressions,the estimated
coefficient on expected inflation obtained by JOH ranges from 1.34 to 1.37, and
when we adjust for the effects of taxes, the estimatedeffect is in the 0.97 to 1.01
range. Knowledge of the small-sampledistributionsof the estimatorsstrengthens
the case that these are accurateestimates of the magnitudespredictedby the Fisher
relation.

3. DYNAMIC IMPLICATIONSOF THE FISHEREQUATION

Evidence of cointegrationis consistent with the theoreticalimplications of the

generalizedFisher hypothesisgiven by equations(1) or (2). The data are consistent
with the long-runequilibriumrelationshiplinking nominal interestrates and infla-
tion; the long-run nominal rates adjust more than one-for-oneto inflation innova-

17. A considerablenumberof experimentswere conductedand are summarizedin a table of results

which are not presentedfor brevity,but are availableupon request.

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 112 : MONEY, CREDIT,AND BANKING

tions; and the excess adjustment,thatis, morethanone-for-one,can be explainedby

the marginaltax rates on interestincome. We now examine the implicationsof this
long-runrelationfor explainingthe behaviorof the two series throughtime.

A. Error Correctionand Causal Relations

We can gain considerableinsight aboutthe dynamicsof the system from the error
correctionrepresentation

k-1
AX,=8+IIX,_1+ E rj5X,j+e, (3)
j=l

where X, denotes the bivariate vector comprising nominal interest rates and tax-
adjustedinflationand where II = aL,B' and aLand ,Bare 2 x 1 vectors in our applica-
tion. Table2 presentsa summaryof VECM parameterestimatesobtainedby impos-
ing the restrictionthat only the error correctioncoefficient from the interest rate
equation (aLi)is statistically significant.18 This implies that lagged deviations from
long-runequilibria,deviationsfrom the equilibriumafter-taxreal interestrate, have
no significant effect on future inflation. We can interpretthis as evidence of weak
exogeneity of inflationwith respectto the parameterspace ,B.Once weak exogeneity
is established, the strong form of exogeneity can be inferredfrom the F-tests, that
is, standardGranger-Simscausalitytests. The F-tests reveal thatlagged interestrate
changes have no significanteffect on inflationgrowth. Therefore,we can conclude
that inflationis also stronglyexogenous. As we see below this has implicationsfor
the dynamic behaviorof the system. The estimateof aLiwhen the zero restrictionon
aLsis imposed is-0.10 with a standarderrorof 0.02, which is still significantat
high levels . The likelihood ratio test of the joint restrictionsthat ,B= [ 1,-1 ] ' and
aLs = O yields a X2(2) statistic of 0.89 which displays no evidence against these
restrictions.

B. InnovationsAnalysis
The dynamicresponsepatternof nominalinterestratesand inflationcan be exam-
ined from the permanentand transitorydecompositionemployed by Stock and Wat-
son (1988) who note that a nonstationaryvector process may be expressedas

Xt = XO + C(1) E es + ,ut ' + C*(L)et (4)

< s=l S

where the term in bracketscapturesthe randomwalk componentsof the vector pro-

cess and the remaining terms define the transitorycomponents. When the system

18. The resultis robustto choice of lag length. For lags threethrougheight the errorcorrectiontermis
always significantin the interestrate equationand insignifi¢antin the inflationequation. Point estimates
at other lags are similarto those presentedin Table4.

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 -.0150 | l | T T W W l | | W X l W [ [ l l H H l

WILLIAMJ. CROWDERAND DENNIS L. HOFFMAN : 113

TABLE 2
VECTORERRORCORRECTION
MODELESTIMATES:
TAX ADJUSTEDDATA
al 7r F' F' F' F7r
-0. 1 108 0.0601 12.32 1.09 0.96 10.69
(0.0203) (0.0661) P = 0.00 P = 0.34 P = 0.38 P = 0.00
NOTES:Numbersin parenthesesare standarderrors.FJ are F-tests of the joint significance of lagged variablevariablej in the equationin
which variable i is the dependentvariable, for i andj = Ai and ATr.P-values are given below the F-statistics.

exhibits cointegration,C(1) = ,Bl(aLlIl*(l),Bl)-laLlwhereIl*(1) is the total impact

matrix of the short-rundynamics in (4), and vector complements, 1 and aLl are
orthogonalto ,Band aL,respectively.
Knowledge of cointegrationrankandevidence from the VECM is useful in defin-
ing the response of the system to innovationsin the permanentand transitorycom-
ponents. Our results suggest that ,B' = [1,-1] and that the second element of aLis
zero. Hence, we can set a1= [0, 1] and ,B1 = [1, 1]. Togetherthese estimates
suggest that innovationsto the second variablein our system (inflation)are exclu-
sively responsiblefor the long-runbehaviorof the system and thatthese innovations
are transmittedequally to both after-taxnominal interestrates and inflation in the
long run.
Figure 2 depicts the patternof impulse response to innovationsin the permanent

Response of Inflat ion Rate Response of Inflation Rate

Shock to /nf/ot/on Shockto Nom/no//nterest
3.0 0.0075
IRF 0.0050 \ , _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

25 - 90X Cont - -
0.0025-
Intervul - -

0.0000
20 -
-.0025-
ll^
I \,
.0050 ,\ _, _ _ _ - - - - - - - - - - - _ _ _ _ _ _ _

I .5 -

-.0075- ,

I .0 - li -.0100-

-.0125- ,
u.> b| I,, X:I, X ^ I,,, l I,, a a ,-rr In1nT r, rrmTrn
1 6 11 16 21 26 31 36 1 6 11 16 21 26 31 36

Responseof NominalInterest Rate Responseof NominalInterest Rate

Shock to /nf/ot/on Shock to Nom/no/ /nterest
l so 0.0100
,'

I 25- 00075 - " t

I .00 - n ' - _
0.0050 \ - - - _ _ _ _ _ _ _ _ _ _

/\ /

0 75 - _,<
0 0025 - 't \_
0.50 -

- - - - - >
0.0000- '
0.25 -
osoo t
-.0025- "
_ _ _ _ _ _ _ _ _

-025 ,, ,,,,,,,,,,, ,,,,,,,, s ,, Wl wT T | | | Wg l | W -.0050 , X,,,,,,,,, l [, T XW],,,, ],,,, ,,,, l,,, l,,,
1 6 11 16 21 26 31 36 1 6 11 16 21 26 31 36

FIG. 2. Impulse Response Analysis

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 114 : MONEY, CREDIT,AND BANKING

and transitoryinnovation, respectively. The impulse response functions are shown

with estimatedconfidencebandsof two standarddeviations.The estimatedstandard
errorsof the IRFs were obtainedthroughMonte Carlo simulationsusing 1,000 rep-
lications. The simulations used to estimate the impulse response confidence inter-
vals were conducted in RATS programminglanguage version 3.11. A permanent
shock to the system causes the Fisher system to move to a new equilibrium. As
discussed above, this shock may be tracedto an inflationinnovationso, as expected,
the inflation rate exhibits a sharp and immediate response to its new steady-state
level while the nominal after-taxinterestrate response to the permanentinnovation
is much slower. Adjustmentto the new tax-adjustedsteady state takes six to eight
years. The slow adjustmentof nominal rates clearly exerts significant downward
pressure on ex post real rates during the transitionperiod. This may explain why
previous researchconcludes that there is a persistentnegative relationshipbetween
inflationand the real rate of interest.
A shock to the transitorycomponentleaves a responsepatternthat is characteris-
tic of a temporaryshock to the after-taxreal interestrate. Ultimately it has no per-
manent effect on the equilibriumthat characterizesthe Fisher equation. However,
the adjustmentperiod is ratherlengthy. This transitoryinnovationresults in a large
initial interestrate responsebut negligible movemenfin the inflationrate. Again the
response of the nominal interestrate is very slow, taking almost six years to adjust
back to the initial equilibriumlevel. The length of time it takes the system to return
to its equilibriumimplies significantpersistencein the real rateof interestand/orthe
. .

rls. ( premlum.

Similarconclusions may be drawnfrom the variancedecompositionresults sum-

marized in Table 3. The permanentinnovationis clearly associated with inflation,
explainingover 90 percentof the forecasterrorvarianceat all horizons. At the same
time the transitorycomponent explains most of the forecast errorvariance in the
nominalinterestratefor up to a year. In longer-termhorizons, the importanceof the
inflationinnovationsbegins to show up.

TABLE 3
VARIANCE DECOMPOSITIONS: INNOVATION TO COMMON TREND
Forecast Horizon Nominal InterestRate InflationRate
1 16.05 [58.20,0.19] 93.85 [99.98,59.21]
2 23.50 [66.54,1.87] 94.89 [99.33, 63.12]
3 30.67 [72.16,4.98] 94.91 [99.43, 62.94]
4 38.15 [76.67, 10.33] 94.85 [99.51, 62.59]
8 62.30 [87.13,31.14] 95.89 [99.48, 66.05]
12 75.87 [89.93,46.70] 96.24 [99.42, 68.50]
16 82.80 [91.70, 56.70] 96.53 [99.36, 70.41]
20 86.71 [92.85, 63.32] 96.65 [99.33, 71.89]
40 93.02 [96.05, 73.52] 97.14 [99.60,74.03]
60 94.74 [97.29,76.39] 97.27 [99.47, 75.41]
NOTES:Numbers in column one representthe forecast horizon. Numbersin columns two and threerepresentpercentagesof forecast error
variance explained by the common trend. Numbers in brackets representthe 95 percent confidence interval around the forecast error
variance.

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 WILLIAMJ. CROWDERAND DENNIS L. HOFFMAN : 115

In the previous section we saw thatapplicationof a fully efficientestimatoryields

estimates that are consistent with the predictionsof the Fisher equation. Once the
long-runsteady state relationis estimatedin this fashion, innovationsanalysis pro-
vides additionalsupportfor the theory. As outlined in the introduction,a common
interpretationof the Fisherrelationis thatnominalinterestratesmay be expressedas
a function of a relatively constantreal rateplus a measureof inflationexpectations.
Our evidence suggests that inflation is strongly exogenous in the bivariatesystem
and accumulatedinnovationsto the inflationrate ultimatelyexplain all of the long-
run variancein both inflationand nominalinterestrates. This is completely consis-
tent with the idea that agents bid nominal interestrates to levels that exceed a sta-
tionaryreal return(adjustedfor conditionalvarianceof inflationandrisk premia)by
an amountthat reflects their inflationexpectations.Therefore, shocks to (expected)
inflation rate must ultimately be reflected in nominal interest rates. Innovations
analysis also suggests that once an innovationhas occurred, whethera permanent
(inflation)or transitory(nominal interestrate) shock, it takes a considerablelength
of time for the equilibriumrelationshipto be restored. These dynamics leave con-
siderable room for a short-runrelationship between real rates and inflation, as
suggested by the Mundell-Tobineffect, but eliminates any long run or persistent
relationshipbetween the two.

4. CONCLUSIONS

This study finds considerablesupportfor a traditional"tax-adjusted" Fisherequa-

tion. In contrast to previous work, we find that a 1 percent increase in inflation
yields a 1.34 percent increase in the nominal interestrate. After adjustingfor tax
effects, this "Fishereffect" is insignificantlydifferentfrom unity as implied by the
textbook Fisher relation. Moreover, our empirical supportfor the Fisher relationis
obtainedwithoutspecificallymodeling any changes thatmay have takenplace in the
dynamicsof inflationover the sampleperiod. We findthatthe likely sourceof differ-
ences between our results and those reportedelsewhere is our choice of Johansen's
reducedrankestimationapproachdesigned to deal with nonstationarydatain a mul-
tivariatesetting. Following Johansen,an estimate of the cointegrationspace is ob-
tained priorto any normalization.We then normalizethe cointegrationspace on the
nominal interestrate to obtain an estimateof the long-runFishereffect. This differs
from previous studies (viz. Mishkin 1992 or Evans and Lewis 1995) that impose a
normalizationpriorto estimation,with the inflationrateas the independentvariable.
Analysis of the small-sampledistributionsof the estimatorswith experimentsde-
signed to simulate the propertiesof inflationand interestrate data reveal sharpdif-
ferences between the LS and maximum-likelihoodestimators. The maximum-
likelihood approachmaintains desirable propertiesespecially when sufficient re-
strictions are available to reduce the parameterspace while the empirical distri-
butions of the LS estimates exhibit appreciabledownwardbias. The restrictions
required to provide precision in the maximum-likelihoodestimates are consis-

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116 : MONEY, CREDIT,AND BANKING

tent with all samples we examine and are maintainedwhen estimating the Fisher
relation.
The results of our analysis have importantimplicationsfor financialmarketre-
search. Evidence of a long-runequilibriumbetween nominalinterestratesand infla-
tion in an after-taxsetting effectively divorces nominal shocks from movements in
the real rate in the long run. However, the ex post real rate (less risk premia)does
exhibit considerable transitory persistence leaving Mundell-Tobinand/or Fried-
Howitt substitutioneffects considerableopportunityto explain the short-runrela-
tionship that is observedbetween real interestratesand inflation.The stationarityof
real rates implied by cointegrationis, of course, consistent with fundamentaltheo-
ries of financial marketbehaviorsuch as the C-CAPM, but continuingwork in the
area should attemptto providebetterexplanationsof the ob.erved persistencein real
rates of return.
Tests reveal that the source of nonstationarityfor both nominal interestrates and
inflation is the random walk accumulation of innovations to the inflation rate.
Campbell and Shiller (1987), among others, presentevidence that yield spreadsin
the term structureof risk-free debt are stationary.Moreover, Campbelland Shiller
(1987) and Gonzalo and Granger(1991) present evidence that it is the short-term
interestrate that serves as the common source of nonstationarityin the term struc-
ture, that is, the shortrate Granger-causeslong rates. Coupledwith our findingthat
inflation innovations are the source of nonstationarybehaviorin short-termrates,
our results are consistent with models where inflationinnovationsdrive the nonsta-
tionarybehaviorof the entire term structure.
We also find, in contrastto Fama(1975), that short-terminterestrates may not be
good predictorsof future inflation. In fact, we have identifiedthe opposite predic-
tive structure.l9But it may take a number of years before the effect of inflation
shocks are fully reflectedin nominal interestrates as evidenced by the variancede-
composition analysis.

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