The Fisher Effect in General Equilibrium Models

The Fisher Effect in General Equilibrium Models There has been much theoretical and empirical interest in the Fisher Effect, di/dπ=1. It is usually portrayed as the result of rational behavior in the credit market resulting from borrowers and lenders exhausting all arbitrage opportunities. Empirical studies of it generally indicate that the nominal interest rate does not rise by the increase in inflationary expectations. Does this mean that the Fisher Effect does not hold, or is it that other variables affected by inflationary expectations feed back into the credit market pushing the nominal rate down, even though the Fisher Effect holds? This paper studies the behavior of the real interest rate in general equilibrium models when the Fisher Effect is constrained to hold in the credit market. A modified Patinkin model with its carefully structured credit market is first studied to determine the behavior of the real rate. The (exogenous) increase in inflationary expectations increases the real rate, the reason being the excess supply (in the bond market) resulting from the inflation induced economization of real balances. When the bond market is generalized to a growth framework to include real income and capital intensity, either real income must fall dramatically or the model is unstable if the real rate is to decline when inflationary expectations increase. Whether the Fisher Effect need hold as a matter of rational behavior is then considered. Life-cycle considerations and general equilibrium adjustments among markets are two important reasons why it need not, and the effect of each is to reduce the real rate