International Review of Economics and Finance 9 2000 181–192
Evaluating the Fisher effect in long-term cross-country averages
Lee Coppock
a
, Marc Poitras
b,
a
Department of Economics, Hillsdale College, Hillsdale, MI 49242, USA
b
Department of Economics and Finance, University of Dayton, Dayton, OH 45469-2240, USA Received 8 February 1999; accepted 23 August 1999
Abstract
This article uses long-term cross-country data to examine the Fisher hypothesis that nominal interest rates respond point-for-point to changes in the expected inflation rate. The analysis
employs bounded-influence estimation to limit the effects of hyperinflation countries such as Brazil and Peru. Contrary to the results in Duck 1993, the present evidence does not support
a full Fisher effect. By extending the empirical model to account for cross-country differences in sovereign risk, we find evidence consistent with the idea that interest rates fail to fully
adjust to inflation due to variation in the implicit liquidity premium on financial assets.
2000
Elsevier Science Inc. All rights reserved.
JEL classification: E40
Keywords: Interest rates; Inflation; Fisher effect
1. Introduction
Irving Fisher postulated that changes in expected inflation leave the real interest rate unaltered by inducing equal changes in the nominal interest rate. The well-known
Fisher effect has important implications for the behavior of interest rates and the rationality and efficiency of financial markets. For these reasons, Fisher’s hypothesis
has inspired a considerable amount of empirical research. Most of the many studies published during the past several decades have failed to detect a full Fisher effect.
Instead, interest rates appear generally to adjust by less than point-for-point in response
Corresponding author. Tel.: 937-229-2419. E-mail address
: poitrasudayton.edu M. Poitras. 1059-056000 – see front matter
2000 Elsevier Science Inc. All rights reserved.
PII: S1059-05609900057-X
182 L. Coppock, M. Poitras International Review of Economics and Finance 9 2000 181–192
to changes in expected inflation. This evidence leads many authors to conclude that financial markets suffer from money illusion.
1
Since studies typically focus only on the short-run, their inability to detect a full Fisher effect is perhaps not surprising; as Fisher himself emphasized, the adjustment
of nominal rates can be expected to occur only in the long-run Fisher, 1930. Recently, however, a number of studies have undertaken to test the hypothesis in the long-run,
and have found support for a full Fisher effect. In particular, Duck 1993 finds evidence of a full Fisher effect by using long-term averages of inflation and interest
rates for a cross section of countries.
2
In this article, we reexamine the Fisher effect in long-term cross-country averages. Our analysis employs bounded-influence estimation to limit the effects of influential
outliers and obtain results that are robust to small changes in the sample used for estimation. In particular, the bounded-influence techniques serve to limit the effects
on the parameter estimates of hyperinflation countries such as Brazil and Peru. In contradiction to the results in Duck 1993, our estimates reject the hypothesis that
government bond rates display a point-for-point Fisher effect; we find instead only partial adjustment of interest rates.
Section 2 describes the data and the empirical techniques. Among other things, we argue that testing the Fisher effect by using long-term averages might adhere more
closely to economic theory than do commonly used long-run techniques such as cointegration analysis. Section 3 presents the results, and section 4 extends the empiri-
cal model to test a hypothesis about the source of partial adjustment. Specifically, we find that the interest rate response depends on the riskiness of the bonds; the tests
reject a full Fisher effect only for those countries with sovereign ratings of investment grade. The result concurs with the Fried and Howitt 1983 theory that financial assets
feature a liquidity premium that increases with expected inflation.
Finally, in section 5 we offer concluding remarks. In particular, we note that our results imply that increasing the liquidity of government securities can lead to greater
stability of interest rates in the face of fluctuating inflationary expections.
2. Data and econometric issues
