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Journal ArticleDOI

The Fundamental Determinants of the Interest Rate

01 Nov 1970-The Review of Economics and Statistics (MIT Press)-Vol. 52, Iss: 4, pp 363-375
TL;DR: In this article, a synthesis of Keynes' theory of liquidity preference and Fisher's model of the role of anticipated inflation is presented, and the analysis is extended to a more general portfolio balance model by introducing privately held government debt.
Abstract: This paper assesses the fundamental determinants of changes in the long-term interest rate. Most recent studies of bond rates have emphasized the term structure relations between the bond rate and short-term interest rates.1 Although we recognize that the individual investor is very much influenced by arbitrage opportunities between different maturities, we wish to look behind the intercorrelated structure of interest rates to the economic forces that shift the entire level of interest rates. The result of our analysis is a synthesis of Keynes' theory of liquidity preference and Fisher's model of the role of anticipated inflation. Our estimates also show the importance of the public debt and of investors' expectations of future changes in the interest rate. We begin our study (section I) by considering a very simple, but nevertheless effective, liquidity preference theory. This is then generalized in a variety of ways by subsequent sections. Section II introduces the important effects of expected inflation, emphasized by Irving Fisher as early as 1896, but generally ignored by economists in more recent years. In section III, the liquidity preference theory is extended to a more general portfolio balance model by introducing privately held government debt. Section IV explicitly considers the implications of expected interest rate changes. Finally, section V examines flow disturbances that may cause the interest rate to depart from the equilibrium level. In sections I through V, the analysis deals with the average yield to maturity on "seasoned" Moody's Aaa corporate bonds, i.e., high grade bonds that are already several years old and have approximately 25 years to maturity. The yield to maturity includes a capital gain (or loss) if the current market price of the bond is less than (or greater than) the redemption value. No allowance is made for the special tax status of capital gains and the resulting distortion in yields during periods of substantial changes in coupon rates. To remedy this, section VI applies the generalized liquidity preference inflation model of section V to the yield on newly issued Moody's Aaa bonds instead of the yield on seasoned bonds. Section VII uses the generalized liquidity preference inflation equation to decompose the change in interest rates since 1954 into the separate effects of the several variables. A concluding section summarizes the results. The estimates generally relate to the 62 quarters from 1954:1 through 1969:2. The use of this period avoids the special characteristics imposed on the bond market by government behavior before the Treasury accord and unpegging of interest rates in 1951. Further details about the definitions of the variables used and the methods of estimation are discussed in the sections that follow.
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TL;DR: The concept of the Fisher effect has been widely accepted among economists and has played an important role in monetary theory, finance, and macroeconomics as discussed by the authors, and it has been used to explain the relationship between the real rate of interest and inflation.
Abstract: THE EFFECT OF INFLATION on the returns to financial assets has been an important theoretical issue for many years. Due to our recent experience with unusually high rates of inflation, this effect is now of considerable practical importance. The basic theoretical concept in this area is commonly attributed to I. Fisher [1930] who posited that the nominal interest rate fully reflects the available information concerning the possible future values of the rate of inflation. This hypothesis, known as the "Fisher effect," has received wide acceptance among economists and has played an important role in monetary theory, finance, and macroeconomics. Others have extended Fisher's original insight to further explain the relationship between the interest rate and inflation. For example, Mundell (1963) uses the Pigou real balance effect to show that the real rate of interest is inversely related to inflation. Conversely, Santomero (1973) argues that changes in population may give rise to a direct relationship between the real rate of interest and inflation. The

477 citations

Posted Content
TL;DR: In this paper, a crucial cause of the failure of share prices to rise during a decade of substantial inflation was discussed, and it was shown that the share value per dollar of pretax earnings actually fell from 10.82 in 1967 to 6.65 in 1976.
Abstract: This paper discusses a crucial cause of the failure of share prices to rise during a decade of substantial inflation. Indeed, the share value per dollar of pretax earnings actually fell from 10.82 in 1967 to 6.65 in 1976. The analysis here indicates that this inverse relation between higher inflation and lower share prices during the past decade was not due to chance or to other unrelated economic events. On the contrary, an important adverse effect of increased inflation on share prices results from basic features of the current U.S. tax laws, particularly historic cost depreciation and the taxation of nominal capital gains.

365 citations

Journal ArticleDOI
TL;DR: This article showed that although the relationship between deficits and short-terrn interest rates may be tenuous, there is strong evidence that larger deficits are associated with higher long-term interest rates.
Abstract: IT IS GENERALLY ASSUMED ON THEORETICAL GROUNDS that increases in government borrowing cause interest rates to rise. 1 But empirical support for this proposition has been weak at best. Several recent papers have uncovered no strong relationship between deficits and short-terrn interest rates. However, the research reported here indicates that although the relationship between deficits and short-terrn interest rates may be tenuous, there is strong evidence that larger deficits are associated with higher long-terrn interest rates. Much of the debate about whether there is a strong relationship between federal borrowing and interest rates concerns the crowding-out question. This controversy centers on the direct and indirect eilffects of government fiscal actions on private spending. These effects have been well documented in the theoretical literature (e.g., Buiter 1977; Carlson and Spencer 1975; Blinder and Solow 1973). Many of the crowding-out effects studied in this literature depend on the connection between government borrowing and high interest rates (Friedman 1978; Meyer 1975; Silber 1970). This is called "short-run indirect crowding out" and may occur when increases in government spending (and borrowing) cause interest rates to rise, which then may cause private spending to be reduced (Buiter 1977, pp. 310-13).

303 citations

References
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"The Fundamental Determinants of the..." refers methods in this paper

  • ...We have used the more general hypothesis of a distributed lag with weights constrained to satisfy a third degree polynomial (Almon [2])....

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