A Study of Interest Rates in the Longer Run: Now You Know the Rest of the Story

Abstract

Do nominal rates of interest change with inflation expectations, changes in expected real rates of interest or both? By 1996, nominal interest rates, inflation, and money supply growth in the United States and six industrial countries had significantly retreated from peak levels in the early 1980s. In explaining the rise of nominal yields, in these countries, up to the 1980s, this paper finds evidence for both higher inflation and higher real rates of interest. In contrast with the idea that variations in nominal yields are principally the product of variations in expected rates of inflation, this paper finds evidence that real rates of interest were non-constant in all countries. After 1981, lower rates of inflation in all countries were eventually manifested, sooner or later, in lower rates of interest. Simple tests of significance provide more support for the inflation-interest rate connection than do cointegration tests. While simple tests of significance suggest evidence that changes in real rates of interest contributed to changes in nominal yields, tests of cointegration provide little or no support for this position.