Testing the Fisher Effect in Croatia: An Empirical Investigation

In his celebrated book The Theory of Interest Irving Fisher asserted that a percentage increase in the expected rate of inflation would lead to a percentage increase in the nominal interest rates assuming that real interest rate is constant. The so-called Fisher effect suggests that changes in the nominal interest rate reflect the revised inflation expectations; and revised inflation expectations have an impact on the level of the nominal interest rate. Consequently, the monetary authorities should employ strategies that will prevent inflation from rising if nominal interest rates are to be kept at low levels in order to not discourage the borrowing. The aim of this paper is to empirically test the Fisher effect in Croatia using VEC (vector error correction) model. The results suggest that the “full” Fisher effect in Croatia may de facto hold only in the long-run. This paper is organized as follows. Section 2 after the introduction, reviews the literature. Section 3 reviews used data while Section 4 describes methodology, empirical analysis and the results. Finally, Section 5 provides some concluding remarks.