Adaptive versus rational expectations and the Fisher effect

Abstract

Substantial controversy remains over the causes of interest rate fluctuations. This controversy frequently focuses on the role of expected inflation. The theoretical determinats of the nominal rate are examined usig the IS&/LM/AS model and it is shown that the augmented Fisher equation is sensitive to the expectations generating mechanism. The model assumes that the nominal rate ceteris paribuschanges one-for-one with expected inflation. The total impact, however, may take any value from zero to one. The empirical analysis sequentially estimates reduced form equations based on adaptive and rational expectations. The results confirm prior findings that nominal rates do not adjust one-for-one with inflation. The results also yield some insight on the applicability of the assumption of rational versus adaptive expectations.