Measuring the Expected Real Rate of Interest: An Exploration of Macroeconomic Alternatives

Abstract

At least since the time of Irving Fisher, it has been clear that nominal rates of interest differ from real rates not because of current or past price level changes but because of expected future price level changes. Accordingly, while nominal rates of return on fully discounted notes are observable magnitudes, expected real returns on the same notes are nonobservable. Nevertheless, real rates of return and real rates of interest are important concepts in the development of contemporary macroeconomic theory, particularly so as that theory develops richer theoretical roles for real rate and inflationary expectations measures. Furthermore, questions such as whether real rates are constant over time or are subject to systematic fluctuation through time reflect attributes of financial behavior that have important implications for understanding macroeconomic adjustment mechanisms. Even so, little attention has been given to the problem of forming and evaluating empirical measures of temporal movements in real rates of interest.' The work done by Fisher and several contemporary followers has proceeded on the premise the expected real rates of interest are constant over time. This theory has usually been examined empirically by estimating a model of the form:2

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