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Inflation Uncertainty and Interest Rates: Theory and Empirical Tests

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  • Richard Hartman
  • John H. Makin

Abstract

This paper develops two models, one involving risk neutrality and the other risk aversion, which suggest that inflation uncertainty affects interest rates. Both models give rise to essentially the same interest rate equation for estimation. Empirical evidence supports the hypothesis that inflation uncertainty affects interest rates. Interpreted in terms of the risk neutral model, the empirical results suggest that inflation uncertainty has a negative impact on nominal interest rates and a positive impact on the expected real rate. If the results are interpreted in terms of the risk averse model, inflation uncertainty has a negative impact on nominal interest rates. The expected real rate is not of direct interest in a risk averse world. The results raise real questions about the use of the Fisherian definition of the real interest rate in situations when there is uncertainty about inflation rates. It is argued that even with risk neutrality the Fisherian definition of the real rate is not the appropriate concept upon which to base economic decisions if inflation uncertainty is present. The appropriate concept is an expected real rate which involves an adjustment for uncertainty. Moreover, if the world is risk averse, the expected real rate is not a relevant concept for economic decisions.

Suggested Citation

  • Richard Hartman & John H. Makin, 1982. "Inflation Uncertainty and Interest Rates: Theory and Empirical Tests," NBER Working Papers 0906, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:0906
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    References listed on IDEAS

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    1. Gibson, William E, 1972. "Interest Rates and Inflationary Expectations: New Evidence," American Economic Review, American Economic Association, vol. 62(5), pages 854-865, December.
    2. Boonekamp, C F J, 1978. "Inflation, Hedging, and the Demand for Money," American Economic Review, American Economic Association, vol. 68(5), pages 821-833, December.
    3. Fischer, Stanley, 1975. "The Demand for Index Bonds," Journal of Political Economy, University of Chicago Press, vol. 83(3), pages 509-534, June.
    4. Charles Engel & Jeffrey A. Frankel, 1982. "Why money announcements move interest rates: an answer from the foreign exchange market," Proceedings, Federal Reserve Bank of San Francisco, issue 6, pages 1-36.
    5. Eden, Benjamin, 1976. "On the Specification of the Demand for Money: The Real Rate of Return versus the Rate of Inflation," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1353-1359, December.
    6. R. W. Hafer & Scott E. Hein, 1982. "Monetary policy and short-term real rates of interest," Review, Federal Reserve Bank of St. Louis, vol. 64(Mar), pages 13-19.
    7. Zellner, Arnold & Palm, Franz, 1974. "Time series analysis and simultaneous equation econometric models," Journal of Econometrics, Elsevier, vol. 2(1), pages 17-54, May.
    8. Fama, Eugene F, 1975. "Short-Term Interest Rates as Predictors of Inflation," American Economic Review, American Economic Association, vol. 65(3), pages 269-282, June.
    9. Mishkin, Frederic S., 1981. "The real interest rate: An empirical investigation," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 15(1), pages 151-200, January.
    10. Peek, Joe, 1982. "Interest Rates, Income Taxes, and Anticipated Inflation," American Economic Review, American Economic Association, vol. 72(5), pages 980-991, December.
    11. Blejer, Mario I. & Eden, Benjamin, 1979. "A note on the specification of the fisher equation under inflation uncertainty," Economics Letters, Elsevier, vol. 3(3), pages 249-255.
    12. Martin Feldstein, 1983. "Inflation, Income Taxes, and the Rate of Interest: A Theoretical Analysis," NBER Chapters, in: Inflation, Tax Rules, and Capital Formation, pages 28-43, National Bureau of Economic Research, Inc.
    13. Levi, Maurice D & Makin, John H, 1978. "Anticipated Inflation and Interest Rates: Further Interpretation of Findings on the Fisher Equation," American Economic Review, American Economic Association, vol. 68(5), pages 801-812, December.
    14. Rothschild, Michael & Stiglitz, Joseph E., 1970. "Increasing risk: I. A definition," Journal of Economic Theory, Elsevier, vol. 2(3), pages 225-243, September.
    15. Robert Mundell, 1963. "Inflation and Real Interest," Journal of Political Economy, University of Chicago Press, vol. 71, pages 280-280.
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    Cited by:

    1. John H. Makin & Vito Tanzi, 1983. "The Level and Volatility of Interest Rates in the United States: The Roles of Expected Inflation, Real Rates, and Taxes," NBER Working Papers 1167, National Bureau of Economic Research, Inc.
    2. Bradford Cornell, 1986. "Inflation Measurement, Inflation Risk, And The Pricing Of Treasury Bills," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 9(3), pages 193-202, September.

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