The Fisher Relationship under Different Monetary Standards: Note

Abstract

Since Milton Friedman's presidential address to the American Economic Association in 1967 [7], many articles have appeared in the literature attempting to estimate the relationship between nominal interest rates and the expected rate of inflation. As described by Irving Fisher [6], the nominal interest rate is the real rate of interest plus the expected rate of inflation. Unfortunately, the expected rate of inflation cannot be directly observed, necessitating the use of proxy variables derived from implicit models of expectation formulation. The usual procedure used to estimate the Fisher relationship is to regress the nominal rate of interest on past values of inflation and then assume that the estimated coefficients are the weights in an autoregressive model of expectations formulation. This approach has produced mixed results. Although the rate of inflation during the recent past has large, positive coefficients in regressions for the postwar period [4, 5, 15, 18], the coefficients are close to zero and involve implausibly long lags in regressions for earlier time periods [8, 9, 12, 14, 16, 17]. This failure to find significantly positive coefficients for past rates of price change in these earlier periods has raised doubts in the minds of some economists about the importance of the Fisher relationship in determining interest rates [1]. However, Benjamin Kelin [11] points out that individuals would consider the monetary standard in forming their price expectations. Under a commodity standard, such as the gold standard period from 1880 to 1915, future rates of inflation would be independent of or even negatively related to past rates of inflation. If this is the case, it would be irrational for individuals to form expectations of inflation utilizing a positive autoregressive scheme. Only under the recent fiduciary standard, where inflation rates are positively autocorrelated, would one expect nominal interest rates to be positively related to past inflation rates.