A Panel Analysis of the Fisher Effect with an Unobserved I(1) World Real Interest Rate

The Fisher effect states that in ation expectations should be re ected in nominal interest rates in a one-for-one manner to compensate for changes in the purchasing power of money. Despite its wide acceptance in theory, much of the empirical work fails to find favorable evidence. This paper exam- ines the Fisher effect in a panel of 21 OECD countries over the period 1983-2010. A first generation panel test finds cointegration between nominal interest rates and infl ation. However, a non-stationary common factor in the error terms of this alleged cointegrating relation is detected using the Panel Analysis of Non-stationarity in Idiosyncratic and Common Components (PANIC). This implies that the regression results are spurious. A possible interpretation for the non-stationary common factor is that it re ects permanent common shifts in the real interest rate induced by e.g. shifts in time preferences, risk aversion and the steady-state growth rate of technological change. We next control for an unobserved non-stationary common factor in estimating the Fisher equation using both the Common Correlated Effects (CCE) and the Continuously Updated (Cup) estimation approach. The impact of in ation on the nominal interest rate is found to be insignificantly different from 1.