The Cross-country Relationship between Interest Rates and Inflation over Three Decades

This paper looks at the relationship between inflation and interest rates across a number of industrialised countries over the past three decades. The paper is in three parts. It begins by splitting the whole period up into a number of smaller periods and looking at the inflation/interest rate relationship across countries within these periods. The most interesting conclusion of this section is that while there was a negative relationship between inflation and real short-term interest rates in the 1970s (i.e. high inflation countries had lower real short-term interest rates), in the 1980s there was a positive relationship between real short-term interest rates and inflation. The paper then discusses some explanations for this observation – why might we expect to see higher real interest rates in high inflation countries and why has this only occurred in the 1980s. Finally the paper uses a simple test to attempt to distinguish between competing explanations of the positive inflation/real interest rate relationship. Unfortunately, the test cannot distinguish conclusively between the competing hypotheses.