The Fundamental Determinants of the Interest Rate: A Comment

Abstract

Martin Feldstein and Otto Eckstein (1970) have set out and estimated a model of interest rate determination which they claim represents an integration of Keynes's liquidity preference theory with Irving Fisher's theory of the impact of expected inflation on interest rates. They achieve their integration by first inverting a Keynesian demand function for real balances, solving it for the nominal rate of interest. Then to incorporate Fisher's effect, they simply add to the right side of this equation a distributed lag in current and past actual rates of inflation, the same proxy for expected inflation that Irving used. Feldstein and Eckstein interpret sizable and statistically significant estimated coefficients on the elements of that distributed lag as confirming the presence of an effect of anticipated inflation on the interest rate. It is questionable whether Keynes's and Fisher's theories stand in need of any integration at all, since they are in principle compatible in the first place. The two theories are on very different footings. Keynes's liquidity preference theory is a theory about one particular structural equation relating real money balances, income, and the nominal rate of interest. On the other hand, Fisher's theory is one about how the whole economy is put together; that is, it is a statement about the reduced form equation for the nominal interest rate. In Fisher's theory, an exogenous increase in the anticipated rate of inflation is asserted to work its way through the economy in such a fashion that the nominal interest rate rises by the amount of the increase in anticipated inflation.1 In this note, I suggest that Feldstein and Eckstein's equation does not successfully synthesize Keynes and Fisher. Furthermore, I suggest that Feldstein and Eckstein's econometric procedure is not a good one for estimating the dimensions of the Fisher effect. In particular, the effect may be present in full force but still not be detected by Feldstein and Eckstein's procedure. On the other hand, it is possible to construct examples of economies in which there is really no effect but in which Feldstein and Eckstein's test would point to the presence of one. Finally, I show that in a model that includes both Keynes's liquidity preference schedule and a reduced form for the interest rate like the one posited by Fisher, Feldstein and Eckstein's equation is not statistically identifiable.