Econometric Analysis of Fisher Effect - Assignment Help

INTRODUCTION

The concept of fisher effect is an economic theory created by economist Irving Fisher. The Fisher effect stated that the movements in the nominal interest rate will reflect fluctuations in expected inflation rates ( Fama, 1975 ). It describes the link between inflation and both real and nominal interest rates. More specifically, when the money supply is increased by a central bank and expected inflation rises, that central bank also increases interest rates. For example, if the nominal interest rate on a savings account is 6% and the expected rate of inflation is 5%, then the money in the savings account is really growing at 1%. Hence, the implication of combining both the quantity theory of money and the Fisher equation will show that movements in nominal interest rates increase simultaneously with inflation rates, that there is a practical effect.

According to Beggs (2019), the quantity of money is the idea that the supply of money in an economy determines the level of prices and changes in money supply result in proportional changes in prices. The growth in money includes the relationship between the nominal interest rate and the expected rate of inflation. Following a certain examination of the data raises the question of why the Fisher effect is not powerful for certain periods. According to Nelson and Plosser (1982), the Fisher effect shows various macroeconomic time series including interest rates and an inflation rate that can be categorized as having stochastic trends. For instance, the inflation process changes over time by examining the forecasting performance of the inflation-change model over different forecasting horizons (3-month, 6-month, 1-year, 2-year, 5-year, and 10-year).

In supporting short-term relationships among interest rates and future inflation, different forecasting horizons have taken into consideration by economists. Another example followed by Granger, Newbold (1974) and Phillips (1986) research upon spurious regression phenomenon informs us of the potential for misleading inference for variables of having stochastic trends. The inflation-change model is run over different forecasting horizons to view the impact of the Fisher effect in the short-run and long-run. There exists a pattern of change in future inflation rates related to the difference in term structures of interest rates at different forecasting horizons. Furthermore, the regression analysis will determine the empirical term structure of interest rate affect future inflation, as one of the important factors for policymakers is inflation. Hence, the following segment shall represent the data, it’s the source and the definition of each variable used in the models.

DATA

Data used for the empirical analysis has been derived from the Federal Reserve Bank of St. Louis. The time series analysis has been obtained by using the monthly data on the U.S. which consumer prices and nominal interest rates over the period Jan-1984 to Feb-2019. The representation of inflation is the U.S Consumer Price Index (CPI) for All Urban Consumers (All items, Index 1982-1984 = 100, Monthly, Not Seasonally Adjusted) sourced from the U.S Bureau of Labor Statistics. Furthermore, nominal interest rates are represented as 3-month, 6-month, 1-year, 2-year, 5-year and 10-year Treasury Constant Maturity Rate (Percentage, Monthly, Not seasonally adjusted) that sourced by the Board of Governors of the Federal Reserve System (US).