Posted on February 12th, 2008 at 2:45 pm by wswanson
How have I not posted in 8 days? I’ll just post on this topic again, becuase Im sure there is something I’m supposed to be doing. In the article, Thomas Sargent proposes a method to empirically test Irving Fishers hypothesis about real and nominal interest rates in the face of inflation. This hypothesis has two formulations:
1) An increase in the rate of inflation will produce an equivalent jump in the nominal yield of bonds over the given time of maturity. In the long run, a jump in expected inflation will leave the real rate of interest unaltered. However, in accordance with the Keynesian critique of classical economics, the long run may be too long in the future. For this hypothesis to work in the short run, “the LM curve is vertical, the IS curve is horizontal, or the Phillips curve is vertical (as it would be in long run). These assumptions are very monetarist and classicist, along with the conclusion.
2) The more widely accepted Fisher hypothesis is founded on more likely assumptions. First we must assume that by “rational expectations,” we mean that the public will expect whatever the economic model is able to confirm. Thus, expectations are exogenous to the model. Secondly, that the natural rate of unemployment hypothesis is true, and therefore no fiscal or monetary efforts can lower the unemployment rate in the long run. If we assume these, then the real interest rate is independent from the systematic (M1, I think) part of the money supply and nominal rates are influenced only through expected inflation as influenced by the money supply. The difference between 1 and 2 lies in the fact that in 2, we make no assumptions about the slopes of the IS LM curves in the short run. The two assumptions are enough to separate real from nominal rates of interest.
Sargent, Thomas J. “Rational Expectations, the Real Rate of Interest, and the Natural Rate of Unemployment.” Brooking Paper on Economic Activity, Vol 1973, No. 2 (1973), pp 429-480.