Fisher’s Theory of Interest Rates: India

Ritika Sinha

Abstract

This paper examines the hypothesis put forth by Irving Fisher that long run real interest rates

tend to be unaffected by monetary shocks and are determined only by real factors in the economy.

Unit root tests and formal tests of cointegration are used to test the empirical viability of this

hypothesis. The paper concludes that despite the real interest rates being stationary in the long

run, cointegration tests reject the Fisher hypothesis and empirical evidence is hard to find in the

Indian context.
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Applied Time Series and Panel Data

Introduction

Irving Fisher’s Theory of long-run interest rates suggests that a permanent shock to inflation

rates will cause an equivalent change in the nominal interest rate such that real interest rates are

neutral to such inflation shocks. The implication of this hypothesis is that real interest rates will

not be determined by monetary phenomena or shocks, but by real factors such as investment

demand and savings. An inflation shock may occur due to monetary growth or expansionary

monetary policy, leading to a proportionate change in the nominal interest rates due to increased

money supply. According to Fisher’s hypothesis, the real interest rate is the nominal interest rate

adjusted for inflation. The potential earnings that arise due to an increase in the nominal interest

rate are discounted (deflated) by the extent of expected inflation:

ir = in – πe

The original Fisher Equation was given by 1 + in = (1 + ir) (1 + π), which has been

approximated to the above formulation for real interest calculation when savings are not

continuously compounded. According to the Fisher hypothesis, in the absence of any inflationary

monetary shock, the real interest rates should be stable over the long run. This is an important

assumption in many theoretical studies; however, not much empirical evidence exists.

In this paper, the empirical validity of Fisher hypothesis is checked using cointegration tests.

Unit root tests are performed on nominal interest rates and inflation using the Augmented

Dickey-Fuller technique for levels and first differences. Further, these series are tested for

cointegration using the Engle-Granger methodology and the Johansen test. The Phillips-Perron

test for non-stationarity due to structural breaks is also performed. In addition, the real interest

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rate series generated using the above equation is tested for stationarity using the Augmented

Dickey-Fuller and Phillips-Perron tests for unit roots.

Several studies in the past have concluded that there is no long-run relationship between nominal

interest rates and inflation using cointegration tests, contrary to theoretical assumptions. Beyer,

Haug and Dewald (2009) conclude that a structural break in the cointegrating equation leads to a

rejection of cointegration by introducing a spurious unit root in the regression. Using post-war

data for 15 countries, their study indicates that a linear Fisher relation exists in the long-run,

taking structural breaks into account. Sathye, Sharma and Liu’s (2008) study on India using

monthly data over an eight year period shows that the hypothesis is true and that expected

inflation is Granger caused by nominal short term interest rate. Rose’s (1988) paper found that

inflation and inflation forecasts are not unit root processes while nominal interest rates are. It

also finds that ex-ante real interest rates are non-stationary in such cases, without accounting for

ex-post real interest rates. Westerlund (2006) tests the Fisher hypothesis using panel models

instead of univariate tests (which have low power) and finds that the Fisher effect cannot be

rejected.

Context: Indian Economy

In the 70’s and 80’s the government of India was making concerted efforts towards development

and growth. Through this pre-reform period, the financial markets in India were immature and

unresponsive and needed an initial impetus. The short term interest rates were not determined by

the market mechanism but by policy decisions by the central bank. The Reserve Bank of India’s

monetary policy in India supported the government’s inflationary budget deficits. As a result,

until the financial reforms began in the 90’s, interest rates follow an upward path so as to

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encourage investment and also due to control by the RBI. Once financial reforms were

introduced, many controls were abolished and interest rates began to respond to market dynamics.

Since that period, interest rates have been noticed to decline, except in 1997-98. Inflation on the

other hand peaked during the 1973 Oil Embargo and hit its lowest immediately thereafter. An

important landmark for both inflation and interest rates was in 1997-98 during the Asian

financial crisis. Due to the unique path of financial and economic progress, the application of the

Fisher effect is a particularly interesting hypothesis in the Indian scenario.

Data and Methodology

Quarterly data from 1967 to 2008 was retrieved from the Organisation for Economic Co-

operation and Development (OECD) and the International Monetary Fund’s IFS online databases.

Inflation and Rational Expectations: The pure Fisher effect is measured by the difference

between nominal interest rates and expected inflation. Actual inflation (plus a mean zero forecast

error term et) is used as a proxy for expected inflation, assuming rational expectations.

According to the ‘Rational Expectations’ hypothesis, the actual inflation rate in the future will

coincide with the market’s ‘rational’ expectations, or the predicted rate of inflation, given all

available information. Any deviation from this rate would arise only due to an information shock

or discrepancy. Thus, πe = πt + et. Lucas’s analysis of simple asset pricing has yielded the Fisher

equation that is consistent with the rational expectations hypothesis. The measure of actual

inflation used in this paper is Consumer Price Indices percent changes from the same period in

the previous year. CPI measures the average changes in the prices of consumer goods and

services purchased by households. The descriptive statistics and time plot of inflation are shown

in Appendix 1.

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Nominal Interest Rate: Interest is the price paid by the borrower for the use of loanable funds

due to the time preference of money. There are various rates of interest, depending on the

duration, purpose, source, competitiveness of the loan. For the purpose of this paper, the interest

rate in question is the immediate interest rate for call money or the Interbank Rate (per cent per

annum). The descriptive statistics and time plot of the short term nominal interest rate are shown

in Appendix 2.

Test Results: Unit Roots, Cointegration and Structural Breaks

Unit Root Tests were performed on both series using the Augmented Dickey-Fuller test statistics.

Using the Schwarz Information Criterion with maximum 8 lags, the series were tested for unit

roots in levels (with intercept) and in first differences. In levels, the null hypotheses of the

existence of unit roots could not be rejected at the 1% level of significance. The Augmented

Dickey Fuller t-statistics and critical values are reported in Appendix 3. Thus both series are non-

stationary in levels. In first differences, we reject the null hypothesis of a unit root for both

inflation and interest rate at the 1% level. Both inflation and interest rate are difference stationary,

thus they are integrated of the same order [I (1)].

Cointegration

Since the 2 variables are integrated of the same order, they are tested for cointegration using

formal tests. Cointegration refers to the co-movement relationship that exists between 2 variables

when they are both non-stationary (have unit roots) and integrated of the same order but a linear

combination those variables is stationary. If two variables move together, OLS may show a

relationship between them when it does not exist, in other words, it may generate a spurious

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regression. If both nominal interest rates and inflation are integrated of order 1 and their

conditional variances are covariance stationary, a bivariate representation of their relationship is

the cointegrating vector [1, -1]. This cointegrating vector would verify the stationarity of real

interest rates. The formal tests of cointegration used in this paper are the Engle-Granger

methodology and the Johansen test for cointegrating vectors.

Engle-Granger Test of Cointegration

The null hypothesis is that there is no cointegration between inflation and nominal interest rates.

Interest rates, especially in the immediate and short term, reflect monetary shocks. Interest rates

such as the short term bank rate and the call money rate change as per the government’s

changing monetary policy to control inflation. Nominal interest rate is regressed against inflation,

with an intercept. The regression equation is in = α +βπt + et. The time plot of the residuals is

referenced in Appendix 5. The next step is to regress the first difference of the residuals (et) on

the first lag of the series. The equation is ∆et = a1et-1 + εt. The residuals εt are a white noise

process, thus there is no need for an augmented model. Appendix 6 displays the estimation

output. As per the Engle-Granger test for cointegration, we test for the presence of a unit root in

the residual et series. The null hypothesis is a1 = 0. Performing the OLS regression gives the

values reported in Appendix 6. The t-statistic on the first lag of the residuals is -1.39. We cannot

reject the null hypothesis on the basis of Engle-Granger critical values for 100 observations and

two variables at 5% level: -3.398. Thus the residual series contains a unit root and is non-

stationary. The null hypothesis of no cointegration cannot be rejected by the Engle-Granger test.

Even though both the variables are integrated of the same order, there is no linear combination

between them that is stationary, thus they do not have any long term relationship.

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Johansen Test for Cointegration

The Johansen test checks the rank of the unrestricted cointegration vector using two methods: the

trace test and the maximum eigenvalues test. The first method (λtrace statistic) tests the null

hypothesis that the number of cointegrating vectors is equal to the rank r against a general

alternative. For the maximum eigenvalues test (λmax), the null hypothesis of r cointegrating

vectors is tested against the alternative of r+1 cointegrating vectors. Inflation and nominal

interest rates are tested for cointegration using these approaches with an intercept and no trend in

the cointegrating equation and no intercept in the VAR. This specification uses lags 1 through 8

to test for cointegration between the given endogenous variables. The results are reported in

Appendix 7. The Johansen test is unable to reject the null hypothesis that there is no

cointegrating vector at the 5% level of significance, with a λtrace statistic of 16.95271 and a λmax -

statistic of 11.19720. Thus there is no cointegration between inflation and nominal interest rate.

Structural Breaks

Both the Engle-Granger and the Johansen tests find that there is no cointegration between

inflation and interest rates. Using these tests, the long run Fisher hypothesis is rejected in the

Indian context. Beyer, Haug and Dewald find that these cointegration tests are biased towards

acceptance of the null hypothesis that a unit root exists, even when a structural break has

occurred. The Phillips-Perron unit root test is performed on the residuals from the Engle-Granger

method to account for such a structural break, as a correction for the Augmented Dickey-Fuller

procedure. The results are reported in Appendix8. The Phillips-Perron test for unit roots

generates a t-statistic of -1.39 against the Augmented Dickey Fuller critical values. We are

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unable to reject the null hypothesis for the existence of a unit root process. Thus the non-

rejection of the unit root hypothesis by the Augmented Dickey-Fuller test is not due to the

presence of a structural break. There is no cointegration between inflation and nominal interest

rates.

Real Interest Rate

Many studies testing the Fisher effect test the long term stable relationship between inflation and

nominal interest rates by looking at real interest rate. The real interest rate is the difference

between nominal interest rate and inflation. It is thus the expected value of future streams of

earnings from interest accrual deflated by the extent of inflation in the economy. As suggested

before, the real interest rates were constructed using the given two series. The approach

postulated in this section is that of testing real interest rate for the presence of a unit root, using

the Augmented Dickey-Fuller test in levels. The intuition is that real interest rate is a linear

combination of the given macroeconomic variables; hence its stationarity would imply that they

are cointegrated. This would also prove the empirical validity of the Fisher hypothesis in the

Indian context. The descriptive statistics, time plots and results from the statistical tests are

demonstrated in Appendix 9. The series was tested for the presence of a unit root in levels,

according to the Schwarz Information Criterion with a maximum lag length of 8 and no intercept

or trend. Given the t-statistic of -4.41, the null hypothesis that a unit root exists is rejected. The

real interest rate is thus stationary and maybe even mean-reverting to zero, as per its time plot. It

is interesting to note that the formal tests of cointegration using nominal interest rates and

inflation (CPI) data reject the Fisher hypothesis, while the real interest rate is found to be a

stationary I(0) process.

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Conclusion

Formal tests of cointegration lead us to reject the Fisher hypothesis, despite its wide application

in theoretical models. Both the Engle-Granger and Johansen tests find that no cointegrating

relationship exists between inflation and nominal interest rates. Thus in the long run real interest

rates are affected by inflation shocks. This rejection criterion remains unchanged even after the

series are tested for the presence of a unit root due to a structural break. However, unit root tests

on the real interest rate series reveal that this linear combination is stationary while both inflation

and nominal interest rate are non-stationary and integrated of order one. The results found by the

formal tests are inconsistent with those generated by the unit root tests of real interest rates. The

paper concludes that macroeconomic variables that are often near-integrated series (as may have

been the case with inflation) cannot be tested satisfactorily using these simple tests as per

Hjalmarsson and Österholm. Additionally, panel tests and even non-linear specification models

add to the power of cointegration tests. In the Indian context, it was expected that the Fisher

hypothesis would hold due to the predominance of policy and government intervention in the last

three decades. Despite the rejection of the hypothesis by formal tests of cointegration, it is

possible that in the long run, with better estimation techniques, the Fisher effect may be validated.

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References

Beyer, Andreas, Haug, Alfred A. and Dewald, William G., Structural Breaks, Cointegration and

the Fisher Effect (February 27, 2009), ECB Working Paper No. 1013, Available from SSRN:

http://ssrn.com/abstract=1333613

Crowder, W. J. and D. L. Hoffman, 1996, The Long-Run Relationship between Nominal Interest

Rates and Inflation: The Fisher Equation Revisited, Journal of Money, Credit and Banking, Vol.

28, No. 1, pp. 102-118, Available from: http://www.jstor.org/stable/pdfplus/2077969.pdf

Dickey, D.A., and Fuller, W.A. (1979) Distribution for the Estimates for Auto Regressive Time

Series with a Unit Root; Journal of the American Statistical Association, 74, 427-31

Dickey, D.A., and Fuller, W.A. (1981) Likelihood Ratio Statistics for Autoregressive Time

series with a Unit Root; Econometrica, 49, 1057-72

Engle, R.F., and Granger, C.W.J. (1987), Cointegration and Error Correction Representation,

Estimation and Testing; Econometrica, 55, 251-76

Fisher, I. (1930), The Theory of Interest, Macmillan, New York.

Hjalmarsson, Erik and Österholm, Pär, (2007), Testing for Cointegration Using the Johansen

Methodology when Variables are Near-Integrated, IMF Working Paper WP/07/141, Available

from: http://www.imf.org/external/pubs/ft/wp/2007/wp07141.pdf

http://byrned.faculty.udmercy.edu/2003%20Volume,%20Issue%203/Fisher%20Effect.htm

http://en.wikipedia.org/wiki/Cointegration

http://en.wikipedia.org/wiki/Fisher_hypothesis

http://en.wikipedia.org/wiki/Rational_Expectations

http://irving.vassar.edu/faculty/pj/reallyfisher.pdf

http://www.economicexpert.com/a/Fisher:equation.htm

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Jensen, Mark J., (2006), The long-run Fisher effect: can it be tested?, Working Paper 2006-11,

Federal Reserve Bank of Atlanta.

Johansen, S. (1992), Determination of Cointegration Rank in the Presence of a Linear Trend;

Oxford Bulletin of Economics and Statistics, 54, 383-397

MacKinnon, J.G. (1991), Critical Values for Cointegration Tests, Chapter 13 in Long-run

Economic Relationships: Readings in Cointegration, edited by R. F. Engle and C.W.J. Granger;

Oxford: Oxford University Press.

Reddy, Y. V., (1999), “Monetary policy operating procedures in India”, Bank for International

Settlements, (ed), pp 99-109, Available from: http://www.bis.org/publ/plcy05e.pdf

Rose, A. K., (1988), Is the Real Interest Rate Stable?, Journal of Finance, Vol. 43, No 5, pp.

1095–1112, Available from: http://www.jstor.org/stable/pdfplus/2328208.pdf

Westerlund, J. (2008), Panel cointegration tests of the Fisher effect, Journal of Applied

Econometrics, 23,193–233, Available from:

http://ideas.repec.org/p/dgr/umamet/2006054.html#download

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Appendix

Appendix 1

40
Series: INF
35 Sample 1967Q1 2008Q4
Observations 168
30
Mean 7.717653
25 Median 7.302503
Maximum 30.91816
20 Minimum -11.02502
Std. Dev. 5.851856
15
Skewness 0.704609
Kurtosis 6.586152
10

Jarque-Bera 103.9247
5
Probability 0.000000
0
-10 0 10 20 30

Inflation
40

30

20

10

-10

-20
70 75 80 85 90 95 00 05

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Appendix 2

50
Series: INTRATE
Sample 1967Q1 2008Q4
40 Observations 168

Mean 8.494048
30 Median 9.000000
Maximum 12.00000
Minimum 5.000000
20 Std. Dev. 2.191941
Skewness -0.020575
Kurtosis 1.810562
10
Jarque-Bera 9.915190
Probability 0.007030
0
5 6 7 8 9 10 11 12

Interest Rate
13

12

11

10

4
70 75 80 85 90 95 00 05

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Appendix 3: ADF UNIT ROOT TESTS: LEVEL

Null Hypothesis: INF has a unit root

INTRATE has a unit root
Exogenous: Constant
Lag Length: Automatic based on SIC, MAXLAG=8
INF Prob* INTRATE Prob*
t- Statistic t-Statistic
ADF test statistic -2.993400 0.0377 -1.116428 0.7089

Test critical values: 1% level -3.471719 -3.469691

5% level -2.879610 -2.878723

10% level -2.576484 -2.576010

*MacKinnon (1996) one-sided p-values.

Appendix 4: ADF UNIT ROOT TESTS: 1ST DIFFERENCES

Null Hypothesis: D(INF) has a unit root
D(INTRATE) has a unit root
Exogenous: Constant
Lag Length: Automatic based on SIC, MAXLAG=8
D(INF) Prob* D(INTRATE) Prob*
t- Statistic t-Statistic
ADF test statistic -5.283090 0.0000 -15.00393 0.0000

Test critical values: 1% level -3.471987 -3.469933

5% level -2.879727 -2.878829

10% level -2.576546 -2.576067

*MacKinnon (1996) one-sided p-values.

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Appendix 5:

Residuals et
4

-1

-2

-3

-4
70 75 80 85 90 95 00 05

Appendix 6: ∆et = a1et-1 + εt. Residuals generated from the regression of interest rate on inflation.

Dependent Variable: D_RES

Method: Least Squares

Sample (adjusted): 1967Q2 2008Q4

Coefficient Std. Error t-Statistic Prob.

RES(-1) -0.021377 0.015358 -1.391868 0.1658

R-squared 0.011504

Adjusted R-squared 0.011504 Mean dependent var 0.002370

S.E. of regression 0.417750 S.D. dependent var 0.420174

Sum squared resid 28.96953 Akaike info criterion 1.098104

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Log likelihood -90.69169 Schwarz criterion 1.116775

Durbin-Watson stat 1.871704 Hannan-Quinn criter. 1.105682

Appendix7: Johansen Test:

Sample (adjusted): 1969Q2 2008Q4

Included observations: 159 after adjustments

Trend assumption: No deterministic trend (restricted constant)

Series: INTRATE INF

Lags interval (in first differences): 1 to 8

Unrestricted Cointegration Rank Test (Trace)

Hypothesized Trace 0.05

No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

None 0.068000 16.95271 20.26184 0.1343

At most 1 0.035551 5.755508 9.164546 0.2105

Trace test indicates no cointegration at the 0.05 level

* denotes rejection of the hypothesis at the 0.05 level

**MacKinnon-Haug-Michelis (1999) p-values

Unrestricted Cointegration Rank Test (Maximum Eigenvalue)

Hypothesized Max-Eigen 0.05

No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

None 0.068000 11.19720 15.89210 0.2376

At most 1 0.035551 5.755508 9.164546 0.2105

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Max-eigenvalue test indicates no cointegration at the 0.05 level

* denotes rejection of the hypothesis at the 0.05 level

**MacKinnon-Haug-Michelis (1999) p-values

Unrestricted Cointegrating Coefficients (normalized by b'*S11*b=I):

INTRATE INF C

0.322758 -0.369083 0.073409

0.470808 0.014808 -4.349067

Unrestricted Adjustment Coefficients (alpha):

D(INTRATE) -0.050058 -0.054893

D(INF) 0.273726 -0.225260

1 Cointegrating Equation(s): Log likelihood -346.1529

Normalized cointegrating coefficients (standard error in parentheses)

INTRATE INF C

1.000000 -1.143527 0.227443

(0.30341) (2.51597)

Adjustment coefficients (standard error in parentheses)

D(INTRATE) -0.016157

(0.00935)

D(INF) 0.088347

(0.04243)

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Appendix 8: Phillips-Perron test for structural change

Null Hypothesis: RES has a unit root

Exogenous: Constant

Lag Length: 0 (Automatic based on SIC, MAXLAG=8)

t-Statistic Prob.*

Augmented Dickey-Fuller test statistic -1.388310 0.5870

Test critical values: 1% level -3.469691

5% level -2.878723

10% level -2.576010

*MacKinnon (1996) one-sided p-values.

Appendix 9: Real Interest Rate (ir)

Descriptive stats and Time Plot:

60
Series: REAL
Sample 1967Q1 2008Q4
50
Observations 168

40 Mean 0.776395
Median 1.530700
Maximum 20.02502
30 Minimum -21.91816
Std. Dev. 5.686068
20 Skewness -0.932648
Kurtosis 7.998979

10 Jarque-Bera 199.2838
Probability 0.000000
0
-20 -10 0 10 20

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REAL
30

20

10

-10

-20

-30
70 75 80 85 90 95 00 05

Real Interest Rate: Augmented Dickey-Fuller Unit Root test.

Null Hypothesis: REAL has a unit root

Exogenous: None

Lag Length: 4 (Automatic based on SIC, MAXLAG=8)

t- Statistic Prob*

Augmented Dickey- Fuller test statistic -4.040933 0.0001

Test critical values: 1% level -2.579226

5% level -1.942793

10% level -1.615408

*MacKinnon (1996) one-sided p-values.

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