The effects of inflation uncertainty on interest rates: a nonlinear approach


OMAY T., Hasanov M.

APPLIED ECONOMICS, vol.42, no.23, pp.2941-2955, 2010 (Journal Indexed in SSCI) identifier identifier

  • Publication Type: Article / Article
  • Volume: 42 Issue: 23
  • Publication Date: 2010
  • Doi Number: 10.1080/00036840801964757
  • Title of Journal : APPLIED ECONOMICS
  • Page Numbers: pp.2941-2955

Abstract

In this article, we investigate the effects of inflation variability on short-term interest rates within a nonlinear smooth transition regression framework. The test results suggest that only the conditional mean of the inflation is a nonlinear process whereas the conditional variance is time variant but linear. Using the square root of conditional variance as a proxy for inflation risk, we estimate Fisher equation augmented with inflation risk. Although the estimated Fisher equations suggest that inflation risk reduces short-term interest rates, we find that the effects of inflation risk on interest rates are regime-dependent. Particularly, we find that the negative effects of inflation variability on nominal rates are greater in low-inflationary regimes when compared to high-inflationary regimes. On the other hand, it is found that both inflation and inflation uncertainty raise the expected inflation effect.