A long memory test of the long-run Fisher effect in the G7 countries

Abstract

The belief that short-term interest rates respond positively to changes in price level, commonly known as the Fisher effect, are currently being investigated extensively by financial researchers. Over the long run the hypothesis implies the presence of an equilibrium relationship between interest rates and inflation. Early evidence favouring the Fisher effect is found not to be consistent in certain time periods and some countries. This paper examines the presence of the effect in the G7 countries. An ARFIMA (Autoregressive Fractionally Integrated Moving Average) model is employed that generalizes the standard ARIMA by allowing fractional differencing. Based on the generalized ARFIMA estimation, the cointegration hypothesis between short-term interest rates and inflation cannot be supported. Interest rates in the G7 countries are not linked to inflation rate in the long run. The puzzling evidence rejecting the Fisher effect remains as the proposed relationship between interest rates and inflation is not r...