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COINTEGRATION AND SHORT-RUN DYNAMICS OF U.S. LONG BOND RATE AND INFLATION RATE

Krishna M. Kasibhatla

North Carolina A&T State University, USA.

ABSTRACT

According to the Fisher hypothesis the nominal bond interest rate adjusts to changes in the expected rate of inflation. This also implies the efficiency of the financial asset markets. Optimizing behavior of agents in asset markets requires that the nominal yield on bonds and expectations of inflation move in the same direction. The original Fisher hypothesis stipulates a one-to-one relationship between expected rate of inflation and nominal interest rates, unadjusted for taxes. This dynamic relationship between the long-bond yield and expected inflation rate as well as the long-run equilibrium relationship between the two rates, in the presence of the Federal Reserve’s close monitoring of the inflation rate, is investigated using the Johansen and Juselius (JJ) (1990, 1995) cointegration and equilibrium error correction methodology. The empirical results of our study strongly indicate that bond rate and consumer inflation rate are cointegrated. Secondly, bond rate is caused by consumer price inflation and consumer inflation is not caused by bond rate. Further, our empirical results support Darby’s (1975) finding of ‘augmented Fisher effect.’ The implication of this finding is that the interest rate, not adjusted for taxes, has to increase by nearly 1.52 when the inflation rate rises by one unit in order to keep the real rate constant.

Key words: degree of integration, unit root, cointegration, erro-correction, Granger causality

JEL Classification: E4 and E5