ADAPTIVE VERSUS RATIONAL-EXPECTATIONS AND THE FISHER EFFECT

Substantial controversy remains over the causes of interest rate fluct uations. This controversy frequently focuses on the role of expected i nflation. The theoretical determinants of the nominal rate are examine d using the IS/LM/AS model and it is shown that the augmented Fisher e quation is sensitive to the expectations generating mechanism. The mod el assumes that the nominal rate ceteris paribus changes one-for-one w ith expected inflation. The total impact, however, may take any value from zero to one. The empirical analysis sequentially estimates reduce d form equations based on adaptive and rational expectations. The resu lts confirm prior findings that nominal rates do not adjust one-for-on e with inflation. They also suggest that testing for the Fisher effect is a tempest in a teapot. Finally, the results also yield some insigh t on the applicability of the assumption of rational versus adaptive e xpectations.