The adjustment of the real interest rate to inflation

This paper reports tests of Carmichael and Stebbing's (1983) ‘inverted Fisher hypothesis’ that it is the real rather than the nominal interest rate which adjusts to changes in the expected inflation rate. Unlike the earlier analysis, the results presented here are based on a properly specified estimating equation derived from a short-run open-economy macro model. The results support the inverted Fisher hypothesis in the short-run but indicate that there is some overshooting of the real interest rate so that after four quarters about 75% of the effect of an expected inflation change is reflected in real rates while the remainder leads to an increase in the nominal rate.