Short-term Real Interest Rate Research Articles

The Fisher Effect revisited through an efficient non linear unit root testing procedure

As the Fisher Effect is either rejected or accepted without a real consensus in empirical studies, it is interesting to test for a unit root in a local-to-unity framework. Moreover, given the inflation expectation behaviour before and after 1979, we shall let a shift occur at a significant time break of our sample, so as to deal with potential non stationarity in the real interest rates series, instead of using Markov switching regimes models. The main innovation is to rely on structural breaks in the deterministic part while combining this method with an efficient unit root test. Empirical results reject a stochastic trend for the US short-term real interest rate from 1951 to 2000. This is consistent with an ex ante real rate constant over time.

General equilibrium real and nominal interest rates

We derive the general equilibrium short-term real and nominal interest rates in a monetary economy affected by technological and monetary shocks and where the price level dynamics is endogenous. Assuming fairly general processes for technology and money supply, we show that an inherent feature of our equilibrium is that any real variable dynamics, in particular that of the short-term real interest rate, is driven by both monetary and real factors. This money non-neutrality is generic, as it does not stem from any friction such as price stickiness, or from a particular utility function. Non-neutrality obtains because the ex ante cost of real money holdings is random due to inflation uncertainty. We then analyze in depth a specialized version of this economy in which the state variables follow square root processes, and the representative investor has a log separable utility function. The short-term nominal rate dynamics we obtain encompasses most of the dynamics present in the literature, from Vasicek and CIR to recent quadratic and, more generally, non-linear interest rate models. Moreover, our results pave the way to several new nominal term structures.

Financial variables as leading indicators in Greece

This paper presents business cycle stylized facts for the Greek economy and extends the relevant Greek literature in the following directions. First, the index of industrial production (IOP) is used to represent real economic activity and business cycle conditions. Second, the behavior of certain financial variables throughout the various phases of the business cycle is analyzed in order to assess their leading indicator properties. Third, possible non-linearities in these variables are investigated and tested for their relation to the business cycle states. The results imply that the most reliable leading indicators are real Treasury bill rates. Volatilities of real short-term interest rates may also contain useful predictive information for IOP volatility. Finally, mean non-linearities seem to be associated with business cycle asymmetries in the mean.

Modelling the demand for loans to the private sector in the euro area

This article studies the determinants of loans to the private sector in the euro area. Using the Johansen methodology, the study identifies one cointegrating relationship linking real loans, GDP and interest rates. This relationship implies that in the long-run real loans are positively related to real GDP and negatively to real short-term and long-term interest rates. Both the signs and the magnitude of the coefficients suggest that the cointegrating vector describes a long-run demand equation. The short-run dynamics of the demand for euro area real loans is subsequently modelled by means of a Vector Error Correction Model (VECM). A number of specification tests performed on the VECM produce satisfactory results, with tests of stability of the model parameters showing no signs of structural breaks during the sample period (1980: 1–1999: 2). All of this suggests that developments in real loans to the private sector in the euro area can be reasonably explained by the model.

Direct effects of base money on aggregate demand: theory and evidence

Meltzer (The transmission process. Working Paper, Carnegie Mellon University, 1999a) shows that real monetary base growth is a significant determinant of consumption growth in the US, controlling for the short-term real interest rate. In this paper, I show that the same property of base money holds for total output (relative to trend or potential) in both the US and the UK. The standard optimizing IS-LM model cannot account for this result, but I show that it can once the long-term nominal interest rate is included in the money demand function. Because the long-term real rate matters for aggregate demand, the presence of the long-term nominal rate in the money demand function increases the effect of nominal money stock changes on real aggregate demand when prices are sticky.

General Equilibrium Real and Nominal Interest Rates

We derive the general equilibrium short-term real and nominal interest rates in a monetary economy affected by technological and monetary shocks and where the price level dynamics is endogenous. Assuming fairly general processes for technology and money supply, we show that an inherent feature of our equilibrium is that any real variable dynamics, in particular that of the short-term real interest rate, is driven by both monetary and real factors. This money non-neutrality is generic, as it does not stem from any friction such as price stickiness, or from a particular utility function. Nonneutrality obtains because the ex ante cost of real money holdings is random due to inflation uncertainty. We then analyze in depth a specialized version of this economy in which the state variables follow square root processes, and the representative investor has a log separable utility function. The short-term nominal rate dynamics we obtain encompasses most of the dynamics present in the literature, from Vasicek and CIR to recent quadratic and, more generally, non-linear interest rate models. Moreover, our results pave the way to several new nominal term structures.

Inflation and real short-term interest rates - A Kalman filter analysis of the term structure

This paper applies the Kalman filter technique to look at the relationship among real interest rates, inflation, and the term structure of interest rate under the expectations hypothesis. Using quarterly data from 1960:1 to 1991:1 for inflation, three month nominal short term interest rates and long term yields with maturities from one to five years, this paper finds that the expectations hypothesis of the term structure holds up well for the data under the assumptions of a time-varying premium and a random-walk real interest rate. In other words, a reconciliation of the expectations hypothesis with the data is attained by assuming time-varying term premium and non-stationary real interest rate.

Inflation and real short-term interest rates - A Kalman filter analysis of the term structure

This paper applies the Kalman filter technique to look at the relationship among real interest rates, inflation, and the term structure of interest rate under the expectations hypothesis. Using quarterly data from 1960:1 to 1991:1 for inflation, three month nominal short term interest rates and long term yields with maturities from one to five years, this paper finds that the expectations hypothesis of the term structure holds up well for the data under the assumptions of a time-varying premium and a random-walk real interest rate. In other words, a reconciliation of the expectations hypothesis with the data is attained by assuming time-varying term premium and non-stationary real interest rate.

Inflation, real short-term interest rates, and the term structure of interest rates: a regime-switching approach

Inflation, real short-term interest rates, and the term structure of interest rates: a regime-switching approach

Inflation, real short-term interest rates, and the term structure of interest rates: a regime-switching approach

This study explores the implications of the expectations hypothesis by examining the implied term premium, in conjunction with an explicit description of processes generating both inflation and short-term real interest rates., It models inflation and short-term real interest rates using a technique that allows for changes in regimes and generates future forecasts of inflation and real interest rates., The hypothesis is that persistent shifts in the term premium under the expectations hypothesis might come from forecast errors by econometricians if regime shifts are omitted, shifts which are however observed by the agents., This study examines whether persistent shifts in the term premium can be eliminated after taking into account the regime shifts in the processes for inflation and real interest rates., The results indicate that there still exists persistence in the term premium., However the implied term premium generated from regime-switching models shows less persistence than those from ARIMA models., Although the regime-switching model does not reconcile the data with the expectations hypothesis, the results suggest that the persistence of the term premium obtained from a fixed-coefficient ARIMA model may be due in part to systematic forecast errors that are eliminated by allowing for regime changes.,

Modelling the Demand for Loans to the Private Sector in the Euro Area

This paper studies the determinants of loans to the private sector in the euro area. Using the Johansen methodology, the study identifies one cointegrating relationship linking real loans, GDP and interest rates. This relationship implies that in the long-run real loans are positively related to real GDP and negatively to real short-term and long-term interest rates. Both the signs and the magnitude of the coefficients suggest that the cointegrating vector describes a long-run demand equation. The short-run dynamics of the demand for euro area real loans is subsequently modelled by means of a Vector Error Correction Model (VECM). A number of specification tests performed on the VECM produced satisfactory results, with tests of stability of the model's parameters showing no signs of structural breaks during the sample period (1980 Q1 - 1999 Q2). All of this suggests that developments in real loans to the private sector in the euro area can be reasonably explained by the model.

Real Interest Rate Parity under Regime Shifts and Implications for Monetary Policy

We use recently developed cointegration tests that determine the regime shift endogenously to test for bilateral real interest rate convergence (real interest rate parity) in the G7 against the USA in the 1974–95 period. In contrast with previous studies that employed classical regression analysis and standard cointegration tests, our innovative approach provides strong evidence in favour of bilateral real interest rate convergence between the USA and several countries in our sample, in particular for short-term real interest rates. Our results highlight the fact that for a number of countries in our sample (Canada and the UK) monetary policy can act as a stabilization policy tool through its effect on domestic long-term real interest rates, while for others (France and Germany) long-term real interest rate changes are influenced by the US monetary policy stance.

Direct Effects of Base Money on Aggregate Demand: Theory and Evidence

Meltzer (1999a) shows that real monetary base growth is a significant determinant of consumption growth in the United States, controlling for the short-term real interest rate. In this paper, I show that the same property of base money holds for total output (relative to trend or potential) in both the United States and the United Kingdom. The standard optimising IS-LM model cannot account for this result, but I show that it can once the long-term nominal interest rate is included in the money demand function. Because the long-term real rate matters for aggregate demand, the presence of the long-term nominal rate in the money demand function increases the effect of nominal money stock changes on real aggregate demand when prices are sticky.

Comment and Discussion

The Economic Consequences of Disappearing Government Debt Vincent Reinhart and Brian Sack Federal budgetary developments in the United States of late have been fast moving and nothing short of outstanding: The latest projections of the Congressional Budget Office (CBO) peg the federal surplus for fiscal year 2000 in excess of $230 billion, around $50 billion more than its forecast of just six months earlier. For a generation accustomed to mounting government obligations and dire warnings of adverse macroeconomic consequences, a surplus in 2000 amounting to 2.4 percent of nominal GDP—the largest since 1948—would seem to imply a changed economic landscape. Yet these developments are not limited to the United States. Several factors have combined to improve fiscal positions in a number of countries worldwide. Among these factors are cyclical recoveries that have boosted income tax revenue, increases in equity values that have produced capital gains tax windfalls, and spending restraint due in part to spending caps and, in many European countries, a desire to satisfy the fiscal criteria in the 1993 Maastricht treaty. In its latest OECD Economic Outlook, the Organization for Economic Cooperation and Development projects that fourteen of twenty-three countries covered will achieve fiscal balance or surplus over the immediate two-year projection period. Indeed, if one excludes Japan, whose fiscal position is moving in the opposite direction, [End Page 163] the aggregate fiscal balance of the Group of Seven large industrial countries (the G-7) will have swung from a deficit of more than 3 percent of their combined GDP in 1996 to a projected surplus of about ¾ percent by 2001. These developments represent a general shrinkage of governments’ claims on the world pool of saving, rather than a shift in the U.S. government’s demands alone. Will these worldwide shifts from deficits to surpluses, and the consequent declines in government debt, have important economic consequences? For some the self-evident answer is no. An influential body of opinion holds that government debt, because it implies a future stream of taxes to meet interest payments, should not be counted as part of household wealth. In that view the decline in government debt, by itself, has no implications for economic activity or financial market prices.1 Instead, any effects that occur stem only from changes in fiscal policies that condition that path of declining debt. Our interpretation of recent events, however, is inconsistent with this view. After reviewing the recent fiscal experience of the industrial countries, we focus on three separate ways in which the disappearance of government debt has economic effects. In our interpretation the U.S. budget surplus and its projected continuation and deepening represent a change in policy comparable in magnitude to the creation of massive deficits in the 1980s. At that time several prominent economists, including Olivier Blanchard, William Branson, Rudiger Dornbusch, and Martin Feldstein, stressed mechanisms through which a policy conventionally viewed as providing current fiscal stimulus could actually have contractionary effects.2 The core of this insight was that fiscal policy in the 1980s was on a path that implied ever-widening deficits, which would require increasing real interest rates over time.3 Investors in capital markets would bring forward to the present their expectations of higher short-term real interest rates, in the form of higher long-term interest rates, lower stock prices, and a stronger foreign exchange value of the dollar, before the direct stimulus of additional spending would be felt. [End Page 164] One channel for this “expectational crowding out” was thought to be the appreciation of the dollar on foreign exchange markets, as the prospect of a rise in real interest rates in the United States relative to those of its trading partners gave investors an incentive to increase their dollar holdings immediately. There is less reason, however, to bring that aspect of the argument to bear on the present situation. To a first approximation, if mounting surpluses are a generalized world phenomenon, rather than specific to the United States, there would seem to be no need for the dollar’s exchange value to adjust to tilt spending into better balance worldwide. However, the other two mechanisms—those operating through changes in...

What Really Happened to U.S. Bond Yields

Analysts have been able to say surprisingly little about the sources of the very volatile yields of long-term U.S. bonds in recent decades. We used surveys of economists' forecasts to decompose long-term bond yields into expectations of future inflation, expected real short-term interest rates, and the expected bond risk premium. Variation in the bond risk premium accounts for most of the variation in yields from period to period, but declines in all three components have contributed to the decline in yields of the past decade and a half.

Determinants of the expected real long-term interest rates in the G7-countries

The paper investigates which factors determine the expected real long-term interest rates of the G7-countries as a whole within a single equation error correction model. Inflationary expectations are generated using the low frequency component of inflation provided by the Hodrick-Prescott filter. A comparison of the calculated expected inflation rates with those resulting from index-linked and conventional UK bonds suggests this approach to be appropriate. Expected real long-term interest rates turn out to be influenced positively by real short-term interest rates, capacity utilization and structural public borrowing.

Properties of the Monetary Conditions Index

In recent years increasing use has been made in monetary policy analysis of the so-called Monetary Conditions Index (MCI). The index is defined as a linear combination of changes in a short-term real interest rate and in the real effective exchange rate, whose coefficients are equal to the estimated effects of the two financial variables on real aggregate demand or, alternatively, on a price index. The MCI is usually regarded as a measure of the degree of tightness of monetary policy in an open economy. In this paper the properties of the index and its possible uses in monetary policy are investigated by means of a macroeconomic model of the Mundell Fleming Dornbusch type; the reaction of the index to different kinds of aggregate shock is considered. Two possible meanings of the index are discussed: as a measure of the stance of monetary policy in an open economy and as an inflation indicator. It is shown that the index can be misleading in both cases. The MCI is ineffective in signalling changes in the stance of monetary policy in the cases of a financial shock and an exchange rate shock and it may also be misleading in the case of a supply shock. As an inflation indicator the index is also subject to some drawbacks in the case of real shocks. The MCI is to be properly interpreted as a summary measure of the inflationary pressures stemming from the short term real interest rate and the real exchange rate. An MCI constructed for Italy turns out to have been affected in recent years by the wide fluctuations of the lira exchange rate, which were mainly due to shocks originating in the financial and foreign exchange markets.

International linkages between short-term real interest rates

Whereas previous studies have focused on the causal relation between nominal interest rates, this paper examines causal relationships between real rates for the United States and six other countries. Based on evidence from our full sample we find that U.S. and foreign interest rates are not highly informative for one another. This would suggest that even if the United States is regarded as a large player in international financial markets this does not necessarily translate into the transmission of U.S. real interest rates to other countries. However, an examination of various sub-periods of our sample reveals that this conclusion may be sensitive to the U.S. monetary policy regime. We also report results for linkages between European countries which indicate that Germany provides some information on real interest rates in France and the United Kingdom, but not in Italy. An analysis of various sub-periods for the European countries show that the result for France is not robust, with German rates having an impact only in the first period through March 1983. This latter evidence does not provide strong support for the hypothesis that Germany's monetary policy plays a dominant role in the European Monetary System. In general, we would argue that domestic factors play a prominent role in determining real interest rates, quite independently from the influence of interest rates from abroad.

A model of the federal funds market

This paper develops a stochastic general equilibrium model of the federal funds market that incorporates non-Fisherian effects on interest rates stemming from both supply and demand shocks to reserves. Such a model may reconcile the widespread belief in a liquidity effect of money supply shocks with the difficulty many researchers have had in finding empirical support for such an effect. The model also cautions against interpreting the observed negative correlation between the federal funds rate and innovations to nonborrowed reserves as empirical confirmation of the ability of the Federal Reserve to lower short-term real interest rates.

The World Economy

The prospects look good for either strong recovery or sustained growth of output throughout most of the OECD in 1995. The UK, US and Canada have grown at above trend rates this year after entering recessions in 1990 or 1991. Continental Europe followed them into recession in 1992 or 1993. These developments prompted a worldwide loosening of monetary policy which began in North America, where real short-term interest rates fell to around zero in 1992. The loosening of monetary policy in Europe (and the UK) came later and real short-term interest rates remain high at around 3 per cent, suggesting that the European upturn will be at a more moderate pace than elsewhere. This policy relaxation is a significant driving force behind the strength of output in the forecast.