The Harmonic Fisher Equation and the Inflationary Bias of Real Uncertainty
AbstractThe classical Fisher equation asserts that in a nonstochastic economy, the inflation rate must equal the difference between the nominal and real interest rates. We extend this equation to a representative agent economy with real uncertainty in which the central bank sets the nominal rate of interest. The Fisher equation still holds, but with the rate of inflation replaced by the harmonic mean of the growth rate of money. Except for logarithmic utility, we show that on almost every path the long-run rate of inflation is strictly higher than it would be in the nonstochastic world obtained by replacing output with expected output in every period. If the central bank sets the nominal interest rate equal to the discount rate of the representative agent, then the long-run rate of inflation is positive (and the same) on almost every path. By contrast, the classical Fisher equation asserts that inflation should then be zero. In fact, no constant interest rate will stabilize prices, even if the economy is stationary with bounded i.d.d. shocks. The central bank must actively manage interest rates if it wants to keep prices bounded forever. However, not even an active central bank can keep prices exactly constant.
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Bibliographic InfoPaper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1424.
Length: 27 pages
Date of creation: Jun 2003
Date of revision:
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Postal: Cowles Foundation, Yale University, Box 208281, New Haven, CT 06520-8281 USA
Other versions of this item:
- John Geanakoplos & Ioannis Karatzas & Martin Shubik & William D. Sudderth, 2004. "The Harmonic Fisher Equation and the Inflationary Bias of Real Uncertainty," Yale School of Management Working Papers ysm388, Yale School of Management.
- C7 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory
- C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games
- D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
- E41 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Demand for Money
- E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
This paper has been announced in the following NEP Reports:
- NEP-ALL-2003-06-25 (All new papers)
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- James R. Rhodes, 2006.
"DEVOLUTION OF THE FISHER EQUATION: Rational Appreciation to Money Illusion,"
GRIPS Discussion Papers
07-05, National Graduate Institute for Policy Studies, revised Sep 2007.
- James R. Rhodes, 2006. "DEVOLUTION OF THE FISHER EQUATION: Rational Appreciation to Money Illusion," GRIPS Discussion Papers 08-04, National Graduate Institute for Policy Studies, revised Jun 2008.
- Orus, Juan & González, Manuel, 2004. "Inflation-Proof Credits and Financial Instruments. Making the Fisher Hypothesis a Reality," MPRA Paper 343, University Library of Munich, Germany.
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