THE FISHER EFFECT: GRAPHICAL TREATMENT AND SOME ECONOMETRIC IMPLICATIONS

Abstract

IN RECENT YEARS, various economists have presented econometric evidence measuring the influence which commodity price inflation exerts upon market interest rates. Judging from the number of papers devoted to the subject, it has become, in Friedman's words, dynamic growth industry. Each author has inevitably acknowledged the pioneering work of Irving and, indeed, the term Fisher has entered the lexicon of economists to explain the influence of commodity price changes on money interest rates. As is now well known, Fisher's theory holds that in the long run the nominal interest on bonds, iT, can be taken as equal to the real rate of interest, rT, the yield associated with real capital, plus the rate of inflation anticipated by the participants in the market, pT, or i = rT +p. In addition, any permanent change in the anticipated rate of inflation will eventually produce a more or less equal rise in the nominal rate and have little effect on the technologically determined real rate. While at least four of Fisher's books were devoted in one way or another to this subject, his primary theoretical explanation for the supposed relationship is to be found in The Purchasing Power of Money [3]. There, in Chapter 4, titled Periods of Transition, describes a monetary theory of the business cycle concentrating largely on the effects of variation in the real interest rate upon the financial or loanable funds market. These variations in the real rate are produced by and interact with varying degrees of temporary money illusion on the part of savers/ lenders which, among other things, lead to cyclical movements in the desired reserve ratios of commercial banks. Such cyclical movements produce corresponding movements in the money supply which, in turn, constitute the principal motive force in the business cycle once an initial equilibrium is disturbed. It will be the purpose of this paper to present a graphical analysis of Fisher's cycle theory as seen from the loanable funds market. As such, it should complement Samuel Morley's [12] presentation of the cyclical effects of variations in the real wage engendered by imperfect anticipations of inflation as seen from the labor and cornfmodity markets. The integration of both presentations could be taken as an initial step in giving complete graphical treatment to Friedman's Presidential Address before the American Economic Association [5]. In addition, our presentation of Fisher's cycle theory will allow us to comment on some of the purported tests for the effect and the relationship of such tests to Fisher's theory. We will also suggest some modifications by which this theory might be made to fit more modern institutional arrangements and practices.