Do Expected Shifts in Inflation Policy Affect Real Rates?

50 Pages Posted: 12 Apr 2004

See all articles by Martin D.D. Evans

Martin D.D. Evans

Georgetown University - Department of Economics

Karen K. Lewis

University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)

Date Written: August 1992

Abstract

This paper presents a new explanation for the negative correlation between ex post real interest rates and inflation found in earlier empirical studies. We begin by showing that there is a strong negative correlation between the permanent movements in ex post real interest rates and inflation. We argue that such a correlation can arise when people incorporate anticipated shifts in inflation policy into their expectations. Under these circumstances, a shift to lower (higher) inflation will lead to systematically higher (lower) ex post real rates. Using new time series techniques we are able to reject the hypothesis that nominal interest rates were unaffected by anticipated switches in inflation policy in the post-war era. To evaluate the impact of these switches, we then calculate the effects of inflationary expectations upon real rates using a Markov switching model of inflation. Inflation forecasts based upon the estimates of this rational model behave similarly to inflation forecasts from the Livingston survey. When ex ante real interest rates are identified with the Markov models of inflation, we find that ex ante real interest rate does not contain permanent shocks, nor is it related to permanent shocks in inflation.

Suggested Citation

Evans, Martin D.D. and Lewis, Karen Kay, Do Expected Shifts in Inflation Policy Affect Real Rates? (August 1992). NBER Working Paper No. w4134, Available at SSRN: https://ssrn.com/abstract=319591

Martin D.D. Evans (Contact Author)

Georgetown University - Department of Economics ( email )

Washington, DC 20057
United States
202-687-1570 (Phone)
202-687-6102 (Fax)

Karen Kay Lewis

University of Pennsylvania - Finance Department ( email )

The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-898-7637 (Phone)
215-898-6200 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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