Do Expected Shifts in Inflation Policy Affect Real Rates? / Karen K. Lewis, Martin D. Evans.

Format:

Book

Author/Creator:

Lewis, Karen K.

Contributor:

National Bureau of Economic Research.

Evans, Martin D.

Series:

Working Paper Series (National Bureau of Economic Research) no. w4134.

NBER working paper series no. w4134

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 1992.

Summary:

This paper presents a new explanation for the negative correlation between ex post real interest rates and inflation found in earlier empirical studies. We begin by showing that there is a strong negative correlation between the permanent movements in ex post real interest rates and inflation. We argue that such a correlation can arise when people incorporate anticipated shifts in inflation policy into their expectations. Under these circumstances, a shift to lower (higher) inflation will lead to systematically higher (lower) ex post real rates. Using new time series techniques we are able to reject the hypothesis that nominal interest rates were unaffected by anticipated switches in inflation policy in the post-war era. To evaluate the impact of these switches, we then calculate the effects of inflationary expectations upon real rates using a Markov switching model of inflation. Inflation forecasts based upon the estimates of this rational model behave similarly to inflation forecasts from the Livingston survey. When ex ante real interest rates are identified with the Markov models of inflation, we find that ex ante real interest rate does not contain permanent shocks, nor is it related to permanent shocks in inflation.

Notes:

Print version record

August 1992.