The long run relationship between interest rates and inflation in Iran: Revisiting Fisher’s hypothesis

Abstract

This paper analyzes the relationship between interest rates and inflation by using the Johansen’s co-integration approach and then vector error correction model (VECM) approach. It should be noted that this relation has been known as Fisher effect in long run term, so we used the theory of Fisher for theoretical basis. The hypothesis, proposed by Fisher (1930), which states that the nominal rate of interest should reflect movements in the rate of inflation has been the subject of much empirical research in many industrialized countries. The existence of a long run relationship between interest rate and inflation was tested by Johansen’s co-integration test. The result shows that there is one co-integration relation, so there is one co-integration equation too. To estimate the adjustment coefficients, we used VECM. Consequently, the results show that there is a long run relationship between these variables in Iran. Also, the results show that the long run relationship between the weighted average of interest rate is weak, while the long run relationship between rental rates of housing and inflation is strong. Key words: Fisher effect, Interest rate, inflation, vector error correction mechanism.