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Anticipated Inflation and Interest Rates: Further Interpretation of Findings on the Fisher Equation

1978; American Economic Association; Volume: 68; Issue: 5 Linguagem: Inglês

1944-7981

Maurice D. Levi, John H. Makin,

Monetary Policy and Economic Impact

This paper extends the approach first taken by Robert Mundell of employing a general equilibrium model to question the Fisher hypothesis that the real rate of interest is invariant with respect to changes in anticipated inflation. The extension involves the inclusion of a labor sector which rationalizes short-run Phillips curves of positive or negative slope and the incorporation of the effect of taxes on nominal interest as discussed by Michael Darby. A labor market is introduced which clears when money wages demanded by labor suppliers are equal to money wages offered by labor demanders. This implies the existence of income and employment effects arising from changes in anticipated inflation whenever the elasticity of money wages demanded by labor suppliers with respect to actual inflation differs from unity.' For values of such an elasticity below unity, the implied positive impact upon real income arising from a rise in anticipated inflation adds to the impact upon saving arising from real balance effects and thereby increases the effect of a change in anticipated inflation upon the real rate of interest. Taxes on nominal interest earnings produce an additional effect. Our aim is to present a framework within which to consider all of these effects simultaneously.2 The assumption that money wages are rigid downward along with employment of the Correspondence Principle allows us to place limits upon the range of values of the elasticity of money wage demands with respect to inflation. Allowing this parameter to vary over such a range produces, along with other parameter values, comparative static results which are consistent with observable magnitudes. In particular, results are obtained describing the impact of a change in expected inflation on nominal interest and an implied impact on real interest which are consistent with the measured impact discovered by empirical researchers. However, contrary to the assumption of empirical investigators (including William Gibson; Eugene Fama; Kajal Lahiri; and John Carr, James Pesando, and Lawrence B. Smith), our results are also consistent with the hypothesis that neither the real rate of interest nor the after-tax real rate (discussed below), is independent of the expected rate of inflation. The paper consists of three sections. Section I briefly reviews the theoretical literature questioning the independence of the real rate from the level of anticipated inflation implied by the Fisher hypothesis. We present our model and describe its implications for the relationship between nominal and real after-tax interest rates and *Associate professor, faculty of commerce, University of British Columbia, and professor, department of economics, University of Washington, respectively. The U.S. Treasury Department and the Federal Reserve Bank of San Francisco provided financial support. We owe thanks for comments and stimulation to Charles R. Nelson, John Murray, A. L. Annanthanarayanan, and to the managing editor of this Review. All views expressed and any remaining errors are ours alone. 1The key role played in the massive contemporary literature on the Phillips curve by the elasticity of money wages demanded with respect to prices and/or anticipated prices has been ably surveyed by John Rutledge. 2We note that our model is consistent with a changing relationship between unemployment and inflation hypothesized by Irving Fisher (1926). This same model also produces results consistent with Fisher's findings on the impact of anticipated inflation upon nominal interest rates.