The Relationship between Inflation and Interest Rates in the UK: The Nonlinear ARDL Approach

Ismet Gocer,Serdar Ongan

doi:10.2478/jcbtp-2020-0037

Abstract

Abstract This study reconsiders the Fisher effect for the UK from a different methodological perspective. To this aim, the nonlinear ARDL model recently developed by Shin et al. (2014), is applied over the periods of 1995M1-2008M9 and 2008M10-2018M1. This model decomposes the changes in original inflation series as two new series: increases and decreases in inflation rates. Hence, it enables us to examine the Fisher effect in terms of increases and decreases in inflation separately. The empirical findings support asymmetrically partial Fisher effects for the UK in the long-run only for the first period. Additionally, this study attempts to describe and introduce a different version of the partial effect concept for the first time for the UK.

Highlights

Understanding the mechanism and relationship between interest rates and inflation is crucially important for the efficient and timely economic decisions for economic actors instituting monetary policy (Praščević and Ješić, 2019)
We examine the Fisher effect from this perspective by applying the nonlinear autoregressive distributed lag (ARDL) model for the United Kingdom (UK)
The nonlinear ARDL model recently introduced by Shin et al (2004) is applied for the UK

Summary

Introduction

Understanding the mechanism and relationship between interest rates and inflation is crucially important for the efficient and timely economic decisions for economic actors instituting monetary policy (Praščević and Ješić, 2019). In the most common form of below Fisher equation, it is the nominal interest rate, rte is the ex-ante real interest rate, πte is the expected inflation rate and εt is the error term. Under the assumption of rational expectations, the Fisher equation can be rewritten in the following form, since the rate of expected inflation equals the actual inflation rate (πte = πt). If β is higher or lower than 1, this supports a partial Fisher effect (Bayat, Kayhan and Tasar, 2018) In this positive linear form of the equation, rises in inflation rates lead to increases in nominal interest rates, whereas falls in inflation rates reduce them, signifying full or partial Fisher effects (Fabris, 2018)

Methods

Results

Conclusion