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A Tale of Two Effects

  • Paul Evans

    ()

    (Department of Economics, Ohio State University)

  • Xiaojun Wang

    ()

    (Department of Economics, University of Hawaii at Manoa)

This paper adopts a New Keynesian approach to analyze the relationship between nominal interest rates and prices. In this new framework, both a positive relation between interest rates and price levels (i.e., a positive Gibson effect) and a negative relation between interest rates and subsequent price changes (i.e., a negative Fama-Fisher effect) arise when money is supplied inelastically and prices are flexible. Such an economy is subject to Gibson’s Paradox, a long-standing puzzle in monetary economics, and a novel paradox identified here, a Fama-Fisher Paradox. By contrast, economies characterized by elastic money and sticky prices are not so paradoxical since nominal interest rates are positively related to subsequent inflation and ambiguously related to the price level. Empirical analysis of nearly two centuries of data for ten countries supports the new theory.

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File URL: http://www.economics.hawaii.edu/research/workingpapers/WP_05-6.pdf
File Function: First version, 2004
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Paper provided by University of Hawaii at Manoa, Department of Economics in its series Working Papers with number 200506.

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Length: 35 pages
Date of creation: 2005
Date of revision:
Handle: RePEc:hai:wpaper:200506
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  1. Barsky, Robert B & De Long, J Bradford, 1991. "Forecasting Pre-World War I Inflation: The Fisher Effect and the Gold Standard," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 815-36, August.
  2. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1997. "Monetary Policy Rules in Practice: Some International Evidence," CEPR Discussion Papers 1750, C.E.P.R. Discussion Papers.
  3. Barsky, Robert B., 1987. "The Fisher hypothesis and the forecastability and persistence of inflation," Journal of Monetary Economics, Elsevier, vol. 19(1), pages 3-24, January.
  4. Klovland Jan Tore, 1993. "Zooming in on Sauerbeck: Monthly Wholesale Prices in Britain 1845-1890," Explorations in Economic History, Elsevier, vol. 30(2), pages 195-228, April.
  5. Dwyer, Gerald P, Jr, 1984. "The Gibson Paradox: A Cross-Country Analysis," Economica, London School of Economics and Political Science, vol. 51(202), pages 109-27, May.
  6. Thomas J. Sargent, 1971. "Interest rates and prices in the long run: a study of the Gibson paradox," Working Papers 75, Federal Reserve Bank of Minneapolis.
  7. Hafer, R W & Jansen, Dennis W, 1991. "The Demand for Money in the United States: Evidence from Cointegration Tests," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(2), pages 155-68, May.
  8. Robert B. Barsky & Lawrence H. Summers, 1985. "Gibson's Paradox and the Gold Standard," NBER Working Papers 1680, National Bureau of Economic Research, Inc.
  9. Wicksell, Knut, 1907. "The Influence of the Rate of Interest on Prices," History of Economic Thought Articles, McMaster University Archive for the History of Economic Thought, vol. 17, pages 213-220.
  10. Fama, Eugene F, 1975. "Short-Term Interest Rates as Predictors of Inflation," American Economic Review, American Economic Association, vol. 65(3), pages 269-82, June.
  11. Roll, Richard, 1972. "Interest Rates on Monetary Assets and Commodity Price Index Changes," Journal of Finance, American Finance Association, vol. 27(2), pages 251-77, May.
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