The Effects of Inflation on Real Interest Rates

Abstract

One of the most obvious facts of recent monetary history is that high inflation is associated with high nominal interest rates. This association has been interpreted by many as supporting a superneutrality hypothesis: that an increase in inflation will not affect real interest rates in the long run.' However, the bulk of the evidence contradicts superneutrality. Beginning with Irving Fisher (1896, 1930), most empirical investigations have found that fully anticipated inflation has less than a unit effect on nominal interest rates, and thus reduces real interest rates even in the longest of runs. This has been shown under the assumption that expectations are formed rationally (Douglas Pearce, 1979), that they take the form of an arbitrary distributed lag on past inflation rates (Fisher, 1930; William Gibson, 1970), or that they are accurately represented by the Livingstone expectations data (Pearce; Kajal Lahiri, 1976). Lawrence Summers (1983) attempted to measure the long-run effect without an explicit theory of expectations. Regressing long swings in various nominal interest rates against long swings in inflation over various subintervals from 1860 to 1979, he found coefficients consistently less than unity. For the post-World War II era as a whole the coefficients were in the range of 0.5 to 0.75, with standard deviations of 0.08 to 0.33. A few studies have found coefficients close to unity (William Yohe and Denis Karnosky, 1969; Martin Feldstein and Otto Eckstein, 1970; Gibson, 1972; Lucas). But, as several authors have observed (Thomas Sargent, 1976; Robert Shiller, 1980; John Wood, 1981; Summers), these findings are limited to a particular period of U.S. history, approximately 1953-71. Furthermore, even a unitcoefficient would contradict superneutrality of the after-tax real interest rate, which would require a coefficient substantially greater than unity. Even taking into account the other inflation distortions in the tax system, Summers calculated that the coefficient ought to lie in the range of 1.3 to 1.5, far higher than observed. These empirical findings pose a challenge to traditional monetary theory, much of which implies that superneutrality should hold at least approximately. For example, the model of Miguel Sidrauski (1967) implies that the real interest rate should equal the marginal product of capital, which in the long run should equal the representative household's marginal rate of time preference. If this rate of time preference is a constant, then in particular it will be independent of the rate of inflation. If it is positively related to the household's wealth, or utility, then inflation can reduce the marginal product of capital somewhat through what are commonly called Mundell-Tobin effects. That is, higher inflation can reduce the demand for real balances, which reduces real wealth, which lowers the rate of time preference and leads to further capital accumulation.2 But this real balance effect on saving is commonly recognized to be too small to make *Department of Economics, Social Science Centre, University of Western Ontario, London, Canada N6A 5C2. We are grateful to Charles Adams, Norman Cameron, John Chilton, Jacob Frenkel, David Laidler, Ben McCallum, Baldev Raj, Brad Reid, Jack Weldon, John Whalley, Ron Winrck, and two anonymous referees for helpful discussions and comments on earlier drafts. All errors are attributable to transaction costs. 'Robert Lucas (1980) finds empirical support for the hypothesis, which he calls one of the central implications of the quantity theory of money. It has also been adopted by a wide range of more eclectic economists, as evidenced by its endorsement in two of the most popular macroeconomics textbooks (Rudiger Dornbusch and Stanley Fischer, 1981, pp. 454-58; Robert J. Gordon, 1978, pp. 289-91). 2These implications of variable time-preference can be drawn almost immediately from the work of Hirofumi Uzawa (1968). A graphical analysis is presented by David Laidler (1969b), who focuses on the logically equivalent question of the effects of paying interest on money.

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