10 - Two Studies of Interest Rates and Monetary Policy

Summary

In this chapter, I return to economic time series with two examples in detail. First, we'll look at an article by Cumby and Mishkin (1986), “The International Linkage of Real Interest Rates: The European–U.S. Connection.” It makes some very important points and uses some of the methods we have talked about. What is the motivation for this article? There is a very important variable in the economics of the financial markets that our theories indicate should have great influence on the economy, but it is a variable that we cannot directly observe. The variable is the expected or ex-ante real rate of interest (denoted hereafter by rr_th, that is, the expectation at time t of what the real rate of return to holding an h-period bond from time t to time t + h will be). Economists have shown that the rate of interest that is most relevant for borrowing and lending decisions is the expected real rate of interest on the loan. What is the expected real rate of interest? Basically, it is the cost of borrowing money once we take into account the rate of inflation that will prevail over the life of the loan. Inflation is just the percentage rise in the money price of goods and services while the funds are out on loan. In many loans, the stated or nominal rate of interest is known up front.