A study of Fisher Effect in India.

Abstract

In this paper, the relationship between nominal interest rate and inflation is analyzed based on Fisher Effect (FE) theory. As per FE theory, the difference between nominal interest rate and expected inflation is equal to real interest rate. The theory proposes that a rise in expected inflation can lead to positive impact on nominal interest rate when the real interest rate is constant. For analyzing FE, the inflation rate measures based on Core index, Wholesale Price Index (WPI) and Consumer Price Index (CPI) are considered. As per rational expectation hypothesis, the one-period-ahead inflation rate is considered as expected inflation (eInf). The interest rates (IR) associated with call money, treasury bills of 91- and 364-day maturities are considered. The study uses ARDL bounds testing approach and Granger causality test for analyzing the long-run relationship between eInf and IR. The study finds evidence for presence of cointegrating relationship between eInf and IR in India. Contrary to FE theory, the long-run relation between eInf and IR is found to be negative. The extent and significance of long-run relationship varies depending on measures of eInf and IR considered. Along with cointegration, the expected WPI inflation and interest rate measures also exhibit Granger causality in at least one direction. Although, the cointegration is not observed between expected CPI and IR, there exists Granger causality between these variables. This increasing disconnect between eInf and IR could be attributed to adoption of flexible inflation targeting framework, pursual of additional objectives by monetary authority, different sources and types of inflation, etc.