An International Evaluation of the Fisher Hypothesis Using Rational Expectations

Abstract

The Fisher Hypothesis, that the real rate of interest is invariant with respect to changes in the expected rate of inflation, has been the subject of intense empirical scrutiny for many years [3;5;9;13;16; 17;21;22;23;24;26]. Several recent studies have sought to model and measure the impact of other variables besides the expected rate of inflation on the real rate of interest [3;5;16; 17;18;19;25], and two papers, Fama [4] and Lahiri and Lee [15], are notable for their attempts to model expectations rationally. The purposes of this paper are two-fold: to develop explicit, rational expectations models for forecasting inflation and to evaluate the Fisher Hypothesis for long-term interest rates in the United Kingdom, West Germany, Italy, and the United States. An empirical evaluation of the Fisher Hypothesis requires a variable which measures inflationary expectations. Optimal ARIMA (Box-Jenkins) models for consumer price inflation are derived for each country, and forecasts of long-term inflation are calculated. Inflationary expectations computed in this fashion are weakly rational since these forecasts make optimal use of the information contained in the available inflation history.