Abstract:
In this paper we examine the effect of permanent inflation shocks on real interest rates, based on a structural Time-Varying Parameter Vector Autoregression (TVP-VAR) model that accounts for parameter instability, using the most extensive annual dataset that accounts for the entire economic history that dates back to 1310 for France, Germany, Holland (the Netherlands), Italy, Japan, Spain, the United Kingdom (U.K.) and the United States (U.S.). The Fisherian hypothesis of a one-to-one movement of inflation to nominal interest rates can only be rejected episodically, in favour of a Mundell-Tobin effect of less than proportional increase in the nominal interest rate to an inflation shock. Our findings suggest that long-run real interest rates of advanced economies have historically remain unaffected by inflation shocks due to a corresponding one-to-one increase in the nominal interest rate. Hence, the conclusions drawn by the majority of the existing literature based on post World War II samples should be treated with caution, due to sample selection bias.
