Combining Term Structure and Fisher Effects

Abstract

In the previous chapter we investigated two four variable vector error correction models that include either the rate of inflation or a long-term nominal interest rate in addition to the three variables that appear in the equilibrium specification of the demand for real balances. In each of these cases we found evidence for a second cointegrating vector in the form of a Fisher equation (stationary real interest rate) or a term structure relationship (stationary interest rate spread). The purpose of the analysis in this chapter is to integrate these two separate results into a five variable framework. First we examine recursive estimates of the interest semielasticity of velocity conditional on stationarity of the real rate and the interest rate spread. In section 2 we impose a causal chain structure that follows the King, Plosser, Stock and Watson (1991) “common trends” model and orders the permanent shocks prior to the transitory shocks. We then discuss identifying restrictions that provide economic interpretations for two of the three transitory shocks. These identifying restrictions allow us to make tentative inferences on the values of the short-run elasticities of the demand for real balances. Finally, we examine the implied dynamic response patterns to the identified shocks and analyze the robustness of these patterns to the generalization of the specification of the VECM from the smaller models in Chapter 7.