Interest Rates and Expected Inflation, 1831-1914: A Rational Expectations Approach

Abstract

Irving Fisher argued that interest rates contain a premium for expected inflation and assembled a mass of data, both historical and statistical in nature, to support his argument [5; 6; 7]. As a research paradigm, his argument has proven useful in explaining the behavior of interest rates during the post-war period.' However, his original empirical analysis was never persuasive and contemporary studies, using modern statistical techniques, fail to find the Fisher Effect in the data Fisher used. This article examines yet one more time the behavior of interest rates and inflation during basically the 19th Century. This study is different from other contemporary studies in four important ways: First, a Consumer Price Index (as is required by Fisher's theory) and not a Wholesale Price Index is used to measure inflation. Second, expected inflation is modeled using a rational expectations approach. Expected inflation is not simply proxied by a weighted average of past inflation. Third, the Fisher Effect is included in a reduced form model with other determinants of interest rates. The Fisher Effect is therefore tested