Non-linear Co-integration between Nominal Interest Rates and Inflation: An Examination of the Fisher Hypothesis for Asian Countries

Abstract

This paper examines the long-run relationship between nominal interest rates and inflation for a group of Asian countries over the period February 1973–April 2007. We argue that the empirical failure to find evidence supporting the Fisher effect in previous studies may be attributed to the presence of non-linearities in the long-run relationship between nominal interest rates and inflation. We present evidence that the Fisher relation contains significant logistic smooth transition autoregression (LSTAR)-type non-linearity. This type of non-linearity is consistent with inflation targeting and the opportunistic behavior of policy-makers. Applying a non-linear unit root test to the residuals obtained from the Fisher relation decisively rejects the null hypothesis of a unit root against the alternative of non-linear but globally stationary in all the cases.

Keywords:

• Fisher effect
• non-linearity
• co-integration

JEL Classification:

• E43
• C22
• C12

Notes

1. ADF-GLS and Mz_a are state-of-the art unit root tests that have been developed by Ng and Peron (1998).

2. The panel approach has been criticized because it tests the null hypothesis that all the series in the panel are non-stationary; in which case, the null would be rejected if there were only one series that is stationary (Taylor & Sarno, 1998).

3. See Cooray (2003) for literature review.

4. Another common way of testing the Fisher hypothesis is by imposing the restriction that α ₁=1 in the co-integrating vector and testing for co-integration in the restricted model, which is equivalent to testing the stationarity of the real interest rate r _t =i _t −π _t .

5. For more discussion on the transition function, see Terasvirta (1994).

6. The start and end of the sample differ for some countries, see Table 1.