A Cross Country Analysis Of Macroeconomic Stability Economics Essay

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Chapter 2
A cross country overview of Interest rates
A cross country analysis of macroeconomic stability and real interest rates
Macroeconomic stability is important for the sound functioning of an economy. Interest rate is a key macroeconomic indicator that assists the inference on the level of macroeconomic stability of a nation. However, a study conducted on 18 OECD countries reveals that economies at similar levels of economic development have persistent differences in their real interest rates. This was true even for short maturities. By constructing a world interest rate to use as a base for comparison, it was discovered that the variation was partly due to non-tradable. The rest of the variation can be explained by various differences than may occur across countries. The differentials which are reflected in interest rates become a part of the risk premium applied in that country. These differences in real interest rates have a significant negative relationship with output volatility and private consumption growth volatility. A negative relation was also discovered between real interest rates and the net foreign asset position (Groth and Zampolli, 2010).
While the previous study concentrated on similar countries. This study incorporates countries at different levels of development. They find the variations in interest rates affect macroeconomic stability through the financial markets. Shifts in policy will impact the macroeconomy effectively through interest rates by influencing the levels of financing available to the firms and general public. Interest rates can be seen as a demand shock as it impacts output and inflation together (Cecchetti and Krause, 2001).
The concept of macroeconomic stability should be thought of broadly, where multiple objectives and trade-offs are in place. This requires moderate to long term interest rates to be in place, along with other factors (Ocampo, 2005).
Linnemann and Schabert (2003) in their study find that economic stabilization can be achieved by linking inflation to the real interest rate, and increasing nominal interest rates when inflation increases, on a more than one on one basis, if asset markets are relatively perfect. However, in reality, most markets are not, in which case, central banks should either abstain from activity targeting inflation, or include the progression of net foreign assets in its interest rate policy rule. They find that in nations with asset market imperfections which also have high levels of foreign debt, a default premium is added onto domestic interest rates. This prevents the interest rate parity from holding. Also in such a situation, exchange rates must return to their steady state after fluctuating else the real value of foreign debt will escalate. This mechanism of exchange rates will be disturbed by the central banks interest rate policy. Hence it must be understood that macroeconomic stability can be achieved by allowing nominal interest rates to respond negatively to net foreign asset movements.
As the world progresses, some fundamental shocks can create instability. These shocks, such as innovations in terms of trade, or in the world interest rate, alter the structure of economies across the spectrum. However, Purchasing Power Parity rules are beneficial here as they absorb the impact and prevent instability (Uribe, 2003). This mechanism takes place through exchange rates, which affects the inflow and outflow of money. Hence, these fundamental shocks indirectly impact interest rates. If nominal interest rates do not change sufficiently, after there is a change in expectations or inflation, a rise in inflation would effectively decrease real interest rates which have a stimulatory impact on aggregate demand (Kwapil and Scharler, 2010).
Developing nations often use real interest rate targeting as their main policy instrument. If a pure real interest rate peg is being followed, it is observed that the local stability properties of the economy’s Balanced Growth Path are highly dependent on how the cash in advance constraint and the degree of productive externalities are formulated (Chin and Guo and Lai, 2009).
Critical evaluation of Interest rate spread differentials across countries
Interest rate spreads can be highly informative about the future progression of economic activity in a country. This is because interest rates act as the link in the transmission mechanism between monetary policy and output. Apart from policy related information, interest rate spreads reflect information asymmetries that may exist in the market, along with default risk that prevails. The spread between short term private rates and short term government rates was found to have predictive power in the United States and United Kingdom. In Canada, predictive power was instead seen in the spread between long term interest rates. In all these countries, increases in spread were linked to slowed economic activity. This study found no significant results for predictive power in interest rate spreads for Germany, France, Italy and Japan (Browne and Tease, 1992).
In Latin America, a number of financial sector reforms were introduced during the 90’s which resulted in more flexibility and financial deepening. This involved removal of interest rate ceilings, a reduction in reserve requirements etc. This new level of independence has resulted in high interest rate spreads. These spreads are affected by operating costs, non-performing loans, and uncertainty in the macroeconomic environment. High levels of the first two variables increase spread. However, as far as non-performing loans are concerned, this was only true for Columbia. For the rest of the countries, high levels of non-performing loans resulted in smaller spreads. However, the magnitude differs across countries. This has been fairly disappointing for policy makers, who expected interest rate spreads to converge to international levels. However, after the liberalization of interest rates, the 90’s generally saw high levels of interest rate spreads (Brock and Suarez, 2000).
Financial liberalization is theorized to reduce banking spreads. In reality, Hossain (2012) and Beck and Hesse (2009) find that this does not happen. Hossain researches the Bangladeshi market which beck and hesse comment on Uganda. However, reasons for their trends were different.
Bangladesh reformed its financial sector extensively in the 90’s. Banking spreads have over all been very persistent. This can partly be owed to managerial inefficiencies arising from revealed preferences and weak risk management practices as well as technological skills. What was observed is that financial liberalization failed to generate sufficient competition and efficiency in the financial sector. This pointed towards gaps in institutional development. What was recommended were enhanced efforts in developing legal and financial institutions to improve competition and hence effectively reduce spreads (Hossain, 2012).
What was interesting to note in Beck and Hesse’s (2009) study was that they find that the size of Banks in Uganda is a factor that impacts bank spread for their domestic market. This along with persistently high T-bill rates and institutional deficiencies are factors that explain most of the high interest rate spreads. The risk based view sees differences in the composition of the loan portfolio as an additional factor.
Saunders and Schumacher (2000), in their study of seven OECD countries, present the structure of the banking sector as a key influence in spreads. They find that the higher the segmentation, the higher the market power of existing banks, hence, higher the spreads. They saw macro-interest rate volatility as a significant contributor to banking spreads.
Latin American countries, when compared to other developing countries, presented low efficiency in the banking sector, weaker competition, high interest rates and high reserve requirements are reasons for their high spreads (Gelos, 2009). The efficiency in the banking sector was also pointed out by Hossain (2012) as a factor of influence in his study for Bangladesh.
Cross country analysis of the term structure of interest rates
The term structure of interest rates is a useful indicator of the markets expectation of future events. It measures the relationship between the rates of return of securities with varying maturities (John C. Cox, 1985). According to Fama (1984), they contain valuable information and can help predict future spot interest rates. Newer literature suggests that the term structure contains more information about expected returns than it does of future interest rates.
The expectations hypothesis claims that long term interest rates are an average of short term interest rates. This implies that they must follow a similar trend. An analysis of the Euro market which used the Italian market as a proxy for the whole Euro zone, suggest that the long term and short term interest rates are indeed correlated. Empirical evidence proved the hypothesis, that interest rates with varying maturities are indeed linked over time (Musti & D’Ecclesia, 2008).
The term structure of interest rates can be useful for multiple reasons. It plays a critical role as far as understanding the transmission mechanism of monetary policy its concerned. Central Banks influence one policy rate, and the impact is felt across the spectrum. The understanding of how this chain reaction takes place and with what lag is where the term structure of interest rates lends its wisdom. They also help identify the integrity with which the auction system (T-bills) in the country operates, however, when there is a large dispersion in the yields, this model will fail. This was analyzed in the Canadian market, and literature suggested that such institutional factors can actually interfere in the ability of financial markets to completely exploit these opportunities of arbitrage (Godbout, Storer, & Zimmermann, 2002).
However, this ability of term structures to transmit information depends on the structure of policies in the country being analyzed. The Turkish economy finds the term structure of interest rates ability to shed light on the monetary policy, relatively weak. This was because there have been a number of regime changes in Turkey which distort the results. However, it did not fail and does still manage to present some reasonable amount of information about the relationship between term structure of interest rates and inflation, although, it possesses a weakness as far as expectations of future inflation rates are concerned (Telatar, Telatar, & Ratti, 2003).
The Japanese market does not possess long term rate with zero coupon. This automatically makes the short end of the term structure the focus in the economy. This rate of return is also the chosen tool for monetary policy, which only adds to its importance. Empirical analysis revealed no support for the expectations hypothesis in the early 1980’s. However, analyzing the later years has resulted in a number of important conclusions. One of which is that the longer end of the term structure possesses more important information than the shorter end. The expectations hypothesis is accepted for the longer end of the term structure (Nagayasu, 2002).
An analysis of the United States market and its term structure revealed that the relationship between the short and long term interest rates in the US is non-linear (Pfann, Schotman, & Tschemig, 1996).
The financial market of Taiwan, compared to other developed financial markets, is relatively small in size, and not as liquid. However, using data on market yields, empirical analysis reveals a satisfactory term structure of interest rates. This was proved using the spot fitting and forward fitting models. This is important for the domestic economy as they are an emerging economy in the Asia-Pacific region (Lin, 1999).
A review of Demand and Supply side theories of interest rate determination
Supply side theories of interest rate determination
The loanable funds theory is part of the neo classical school of thought, and hence more appropriate for explaining trends in long term interest rates. It deals with the intertemporal allocation of funds, based on the opportunity cost of either consuming or saving, which is represented by interest rates. While savings and interest rates are seen to possess a positive relationship, investment and interest rates have a negative relationship. This investment function represents the demand for loanable funds, which the savings are the supply of loanable funds. Graphically, the interaction of these two presents us with the natural rate of interest. This represents the rate the economy eventually converges towards (Oster, 2003).
The loanable funds theory views interest rates as an equalizer, which helps in the conservation of full employment (Rousseas, 1972).
The supply of loanable funds comes from four main sources, namely, savings (which consist of private as well as corporate savings), dishoarding, bank money and disinvestment. The demand for loanable funds consists of investment demand, consumption demand and hoarding. The loanable funds theory sees savings as the most important source of funds. In today’s world, bank money is seen as the most important component of the supply of loanable funds. It is relatively interest elastic. Hence the rate of interest plays a crucial role here (Mandal, 2007). Anderton (2006) supports this as he criticizes the loanable funds theory for over simplification. The theory’s naïve definition of the sources of demand and supply for loanable funds are far too constrictive. In today’s day and age, when open economies prevail, the reality is much more complexed.
Hansen (1951) extended Keynes criticism of the classical theory to the theory of loanable funds. He says the theory is indeterminate as the intersection of the demand and supply of loanable funds decides the interest rate, which directly impacts investment and savings decisions. The income level acts as a key determinant. However, the level of income cannot be known until the rate of interest is decided.
The liquidity preference theory is superior to the loanable funds theory as far as the definition of money demand and supply is concerned. The loanable funds theory does not include alternative stocks of assets in its money supply which becomes its weakness, as far as explaining the influence on interest rates is concerned. However, liquidity preference theory is also criticized for being narrow as it ignores other determinants of interest rates, for example changes such as a new issue of bonds. Since the supply of money is not disturbed here, liquidity preference theory would have to rely on demand to explain the increase in interest rates, yet it fails to give a definitive explanation (Elwood, 2007).
The theory of rational expectations is based on the idea of individuals making objective decisions after analyzing current as well as past information. It assumes that everyone is rational and will possess all known information and make informed decisions. They will collect information till their marginal cost of collect equates their marginal benefit. This information will be used to make accurate predictions which will effectively enable a state of rest, even as changes occur as they will be expected. This is what leads rational theorists to their laissez-faire policy predictions. Pre announced changes will not affect the market as the people will already expect it. They believe monetary policy is ineffective as it only affects monetary variables and rational people will not be fooled by the money illusion (Elliot, 1986).
In strict accordance to the ration expectations theory, there is no room for term premiums (difference between forward rates and expected spot rates) on interest rates. Any changes in the slope of the yield curve will be the same as the expectations of the market. This means the return on securities is expected, certain and independent of their maturity. This is a very rigid theory for today’s world. However, a modified expectations model lends some flexibility to the model and states that long term interest rates will reflect a term premium, as long term securities are riskier, so their return will be different, something the pure rational expectations theory does not account for. Interest rate changes are expected. This expectations help understand how future interest rates will change (Diziwura and Green, 1996).
What the rational expectations theory ascertains is that bond interest rates should represent all available information. This assumes the correct application of the information by the market to construct a yield probability distribution (Mishkin, 1982).
Demand side theories of interest rate determination
Keynes’s liquidity preference theory has added substantial depth to the theoretical analysis of interest rates. His theory requires one to keep expected inflation constant as real and nominal interest rates are discussed.
The liquidity preference theory stresses on the importance of demand as an explanatory variable for interest rates determination. Keynes accords demand a higher position than supply, due to a complexed relationship in behavioral factors associated with the sources of this demand, namely the transactionary, precautionary and speculative motives. In this theory, the supply of money is exogenously determined by the government, who can influence the interest rates by changing money supply. This change in money supply which will shift the supply curve up and hence bring the economy to a new equilibrium rate of interest (Faruqi, 2011).
While the loanable funds theory saw interest rates as a reward for savings, Keynes’s theory sees interest rates as an incentive for giving up liquidity. Individuals decide the appropriate path for their funds, after analyzing all options and deciding which one offers them the highest benefit. Be it investing in bonds, or maintaining cash balances to hold onto some of their liquidity. The dynamics of the theory are such that the market for bonds dictates the interest rates. If there is an excess demand for funds, people will liquidize their bonds, which will decrease their price, and hence increase the interest rate (Handa, 2009).
Keynes saw liquidity as flexibility and was the first one to think of money as more than just a medium of exchange, but an asset. His theory divides demand for money into transactionary demand, precautionary demand and speculative demand. This speculative motive is what sets his theory on a separate track. While the neo classical theorists believed that holding money in excess is wasteful as some interest is better than none, Keynes argues about the speculative thinking of man who might be willing to sacrifice that’s rate of interest for hopes of market volatility to work to his favor (Oster, 2003).
Rose (1957) finds the main difference between the liquidity preference theory and the loanable funds theory to be one of lags. Liquidity preference theory innately expects individuals to act in the current.
The general theory is an extension of the liquidity preference theory, where the determination of interest rates is done through the intersection of the IS and LM curves. Here the IS curve represents equilibrium in the goods market, while the LM curve represents equilibrium in the money market. These curves simultaneously determine the level of Gross National Product and the price level. The rate of interest is hence determines through a complexed mechanism where the savings and investment balance out in the economy while being subject to simultaneous equilibriums in the good and money markets (Faruqi, 2011).
Inflation, inflationary expectations and the interest rates
Relationship between Inflationary expectations and interest rates.
True expectations cannot be observed, which makes the task of evaluation cumbersome. Changes in expected inflation will not change real interest rates, as nominal interest rates adjusted to these inflationary expectations (Saracoglu, 1984).
There is a certain controversy related to the ability of interest rates to predict inflation. Fama (1977), Soderlind (1998) support the motion, while Mayer and Sahu (1995) and Kane and Resenthal (1982) accept it partially with certain assumptions and changes. However, Tanzi (1980) finds the relationship to be poor.
According to Tanzi (1980), the impact of business cycle changes is felt in real interest rates partly through inflationary expectations. In testing the impact, if inflation is used as the only independent variable, it does not explain all the variation in interest rates, however, if a proxy is introduced for economic activity, the results improve substantially. Hence this suggests that real interest rates do not remain constant over time and instead change with the economic activity. Hence, interest rates are a poor indicator of inflation if economic activity is highly volatile. This is in stark contrast to what Fama (1977), who comments on the efficiency of the treasury bills market by ascertaining that it is efficient in a limited why as long as interest rates are based on expected inflation, which in turn is based on past inflationary trends. The interest rate, he says, is the best predictor of inflationary trends. Soderlind (1998) finds that almost 75% of the variation in the level of inflation can be predicted through nominal interest rates. Interest rates do not explain all of the variation because real interest rates and risk premia, compared to inflationary expectation, have relatively shorter run movements.
Mayer and Sahu (1995) find that if taxation and other inflation non-neutralities are accounted for, nominal interest rates change either exactly point for point or slight more, to given changes in inflationary expectations. Kane and Resenthal (1982) find the relationship exist on a global level if the time invariance assumption of real interest rates is removed and instead it is assumed that at a certain point of time, short term interest rates across the globe (in countries with well-developed financial markets), are identical.
However, what cannot be argued is, that expected inflation is an important determinant of real interest rates, irrespective of the degree of influence it may or may not have. Money supply, as another determinant of real interest rates, also gives information about inflation rates. Monetary shocks contain important information about permanent changes in expected inflation in the future. Since nowadays globalization has restricted the ability of ceteris paribus analysis, such that, the impact of changes in the world market are ignored. Changes in world inflation are important, as they seem to have an almost one on one impact on short run real interest rates. It has been observed that the relationship between changes in short run as well as long run real interest rates and expected inflation is negative. An important implication of this result is the impact of incorrect expectations. If future inflation rates are overestimated persistently, it would result in high levels of real interest rates (Koedijk et al, 1994).
Inflation targeting
Policy rules for inflation targeting
A set of efficient policy rules would be those that result in the lowest possible combination of inflation and output variability. This could be different for every economy. One such policy rule is the Taylor rule. Under this rule, the deviation of inflation from a set target as well as the deviation of the level of actual output from potential output determines the level of nominal interest rates. Central banks that practice inflation targeting focus more on inflation forecasts rather than their actual values. Hence, future estimations and forecasts of inflation and output play a crucial role in the policy making strategies of these banks. Another set of rules is the inflation forecast based rules. This rule is more an equilibrium condition than an explicit instrument rule. The efficiency of a relative policy rule can be determined based on the economy under consideration, the objective function of the monetary authority and the structure of shocks. Each policy rule has its own frontier of preferences of inflation and output variability. The Taylor rule has larger inflation variability than the Inflation Forecast Based (IFB) rules. Hence, the IFB rules are a better choice as far as inflation targeting is concerned (Lopez, 2003).
Brouwer and Regan (1997), in a study by the Reserve Bank of Australia, comment that no rule can actually eliminate all the volatility between inflation and output, however the incorporation of inflation targets increase their efficiency. They advocate efficient Taylor rules that incorporate inflation targeting explicitly, reduce the volatility in question more than price level rules as well as nominal income rules. If the inflation target is credible, it would further reduce the relative volatility under these different policy rules.
Rudebusch and Svensson (1998), define two types of policy rules. Instrument based and target based. The explicit instrument based rules identify monetary policy as based on all available information. This type of strategy is very limiting as no central bank will restrict itself to only certain information. This is why it is not used by any central bank. Target based rules on the other hand, are more appropriate, especially for banks that practice inflation targeting. This type of rule is based on a loss function that represents the deviation of an intermediate target variable from its target level.
However, what must be kept in mind is that instrument rules and target rules have a very blurred distinction as the former can be derived from the latter, and vice versa. Yet, some theorist still advocate targeting rules over instrument rules as they lend flexibility to central banks to use their judgment regarding influences on inflation and output (Kruttner, 2004).
Cross country overview of the impacts of inflation targeting
Inflation targeting as a macroeconomic control strategy has been observed to have many important impacts on the economy of a nation and its effect on inflation and output are the most talked about. However, an important measure of the success of a monetary authority to achieving its goals is the extent on influence their policies have on reshaping expectations of the public. What is observed is that as the credibility of central banks increase, inflation targeting becomes a primary reason in explaining the declining inflation. Inflation is seen to have a long term memory, the length of which is reduced by adopting inflation targeting. This was observed in Australia, Canada, Finland, Israel, New Zealand, Spain, Sweden and UK (Yigit, 2010)
Lucotte (2012) finds that inflation targeting has a large and highly significant positive impact on public revenue collection in emerging market economies. They postulate that the adoption of an inflation targeting strategy should induce more responsible fiscal policy measures. Additionally, they also find that de facto exchange rate flexibility is also associated to the adoption of inflation targeting practices. Aizenman, Hutchison, & Noy (2011) finds that the responsiveness of real exchange rates is strongest for those inflation targeting countries that are export intensive in basic commodities, as they are most vulnerable to disturbances in their terms of trade and exchange rates. This suggests developing nations that usually depend on crop exports benefit largely from inflation targeting strategies.
This is not a surprise as the adoption of inflation targeting to begin with suggests macroeconomic instability, which motivated the central bank to curb inflation through targeting. Developing nations have less efficient financial markets which also disturb their natural adjustment abilities, which create a need for practices such as inflation targeting.
Inflating targeting results in price stability, although the pace with which it impacts the variable in question varies with the type of economy that adopts it. The strict application of inflation targeting has been observed to result in higher output income per capita for industrial as well as emerging economies. It is also suggested that inflation targeting regimes improve an economy’s resilience to shocks (Mollick, Cabral, & Carneiro, 2011).
In the flip side, a host of economists believe that inflation targeting is not a desirable policy goal. Brito and Bystedt (2010) refute this optimistic view of inflation targeting and claim that there is no evidence that inflation targeting, which is measured by the behavior of inflation and output growth, improves economic performance. They find that although inflation targeting does reduce inflation, its deflationary impacts have been overemphasized in previous literature. A significant negative relationship is seen between the adoption of inflation targeting policies and output growth after opportunities of economic growth forgone are accounted for. This is because inflation targeting becomes a hindrance in growth.
Honda (2000) also rejects the hypothesis that inflation targeting increases economic growth. He analyzed inflation targeting for New Zealand, Canada and UK and concluded its insignificant impact on macroeconomic variables.
One possible explanation for this division of ideas could be the differences that exist in the strength of the transmission mechanism as well as structural differences in the economy. Hence it is suggested to be a better technique for developed nations. For turkey it has been a good policy. It has helped curb inflation rates, as well as reduce risk premiums on interest rates. This suggests fiscal policy becomes more credible after the introduction of an inflation targeting policy. Turkey achieved successful results as they saw a fall in output, inflation and interest rate volatility. Their improved interest rate pass-through and fiscal performance has been a very important factor in these positive results (Akyurek, Kutan, & Yilmazkuday, 2011).
Cross country historical review of empirical evidence of the fisher effect
Empirical testing
Support for fisher effect in developed countries
The fisher effect suggests that any change in inflation rates induces a one on one adjustment in nominal interest rates, so real interest rates are left unchanged. There is considerable evidence for long run fisher effect, compared to the short run fisher effect.
The existence of fisher effect was found in post-war Canada and USA. Different interest rates were analyzed, namely, the federal funds rate, the treasury bills rate and government bond rates for varying maturities. For Canada, the same types of interest rates were used, only the bank rate in Canada is called the Bank of Canada Rate. The full fisher effect was accepted only under the assumption of no distortionary taxation on nominal returns. The tax adjusted fisher effect revealed mixed results for the US, and was rejected for Canada (Atkins & Coe, 2008).
An analysis of Belgium, Canada, France, Germany, Ireland, United Kingdom and USA found that inflation that is fully anticipated will have a less than unitary effect on the nominal rate of interest. This results in a reduction in real interest rates in the long run as well, hence an overall rejection of the fisher effect (Koustas & Serletis, 1999).
Fuei (2007) found a positive relationship between the long run nominal interest rates and inflation in Singapore, although he rejects the full fisher effect. The 3-month interbank rate was used for analysis. What was interesting to note was that the coefficient of error-correction terms for the inflation related equations were higher than those for interest rate equations. Interest rates should theoretically move faster than prices which are known to be sticky. This could be attributed to the used of exchange rates as a monetary policy tool to protect the competitiveness of its exports.
In Australia, a long run fisher effect was also found while the short run fisher effect was rejected. The thirteen week Treasury note interest rate was used for analysis. This suggests that long run levels of interest rates reflect inflationary expectations while short run fluctuations are representative of changes in monetary policy. This insight, along with the results indicates towards the ability of short run changes in short run interest rates to reflect the variation in real interest rates, instead of expected inflation (Mishkin & Simon, 1994).
Evidence in developing countries
Literature is very mixed as far as support for the fisher effect is concerned. There is also a debate about whether the fisher effect is more visible in developed nations or developing. A partial fisher effect was found for Pakistan. There was a variation in results, depending on which interest rate was used. This is because the strength of the transmission mechanism is different for every interest rate. The call money rates show a strong long run relationship between nominal interest rates and inflation rates. In Sri Lanka, the money market rate gave the best results, and strongly supported the fisher effect. India also accepted the long run fisher hypothesis using call money rates. Lending and deposit rates did not show very positive results. Saudi Arabia’s empirical evidence was divided as the F statistic supported the existence of the fisher effect but the error correction term rejected the presence of the long run fisher effect. Evidence in Bangladesh was mixed as F-value and error correction term estimates using the lending rate showed evidence of a lacking relationship between long term interest rates and inflation. All these developing countries show evidence of the fisher effect. However a strict one on one relationship was not found (Ahmad, 2010).
In an examination of the fisher effect in Argentina, Brazil, Mexico, Turkey, Malaysia and Korea, substantial evidence of a full fisher effect was found. This study stated that variation in the real interest rate does not refute the fisher effect’s presence, but instead only indicated that it is influenced by other variables as well. There may be common nonlinear deterministic time trends that exist in both series, due to exogenous shocks, such as financial crises, etc. Effects of shocks to the interest rate are felt in the inflation rate for upto 24 months (Maghyereh & Al-Zoubi, 2006).
Another study conducted in turkey also confirmed its long run fisher effect. No empirical evidence was found for the short run fisher effect. The interest rate used was the average savings rate. The study goes on to suggest policy makers to use the presence of the fisher effect to their advantage, by preventing inflationary pressure on the Turkish economy by adjusting interest rates (Incekara, Demez, & Ustaoglu, 2012).
New support and evidence
As time passes, research provides new answers to previously troubling problems. This evolution of economic theory is of utmost importance. A host of different interest rates exists in an economy. An empirical investigation reveals that as the maturity increases, the ability of the fisher effect to explain the link between nominal interest rates and expected inflation strengths. Analysis through the Vector Auto Regressive model reveals that inflation and interest rates are correlated for assets that have a maturity greater than two years. This increase in duration also increases the importance of inflation premium. Policy implications include the long term interest rates ability to shed light on the direction of expected inflation (Fahmy & Kandilb, 2003).
Short term interest and inflation rates have a high probability of containing scholastic errors. This prevents short term evidence of the fisher effect from surfacing. It was also discovered that the fisher effect may be present for some time periods, and not exist for others. This is because of regime changes and innovations that take place in the financial system of an economy. Also major shocks like wars tend to distort figures (Mishkin F. S., 1992).
Coppock & Poitras (1999) find that the movement of interest rates is dependent on the riskiness of the bond they represent. Hence, for countries with sovereign ratings of an investment grade, the full fisher effect was rejected. When conducting a cross country analysis, liquidity differentials must be accounted for during empirical testing. This variation in liquidity premiums also holds back the fisher effect from holding in its full form.
One radical study by Pelaez (1995) suggest reanalyzing the fisher effect and instead recasting it as a relationship between actually inflation and that component of interest rates which represent expected inflation. For this he suggests extracting the inflation from interest rates. He finds that the traditional fisher effect is rejected by leading time series analysis techniques, but the co-integration between inflation and the expected inflation which was extracted from the interest rates is supported.
A review of real interest rate stability
The stability and stationarity of real interest rates can be a very valuable feature of an economy. However, whether interest rates possess the ability to actually be stable is of a debatable nature. The structure of interest rates is quite complexed. This generates innate volatility in interest rates. The fisher hypothesis postulates stability of the real interest rate when it ascertains that nominal interest rates will compensate for inflation on a one to one basis. However, it would be naïve to assume inflation rates to be the sole determinant of interest rates. Hence, relatively stable interest rates is the goal the central banks should, and do aim for. As financial markets expand, sectors emerge, that depend on the volatility of interest rates. Hence that must be kept in mind, when the central banks decide on their policies.
An analysis of the ex-ante short term American interest rate was conducted to investigate whether the real interest rate is in fact stable or not. Empirical results reveal a single unit root in prices as well as short term interest rates but not in inflation. This implies that inflation does not have the unit root interest rates do. Hence, if inflation forecasting errors display stationarity, then that means real interest rates are non-stationary. This proves that real interest rates are in fact, not stable (Rose, 1988).
Research suggests that there is a close relationship between model selection and the stability of the variable in question. This is a warning for theorist to select their models carefully as they could distort important results (Smith, 1998).

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