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Regime Shifts in European Real Interest Rates

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posted on 2006-01-30, 18:04 authored by Terence Mills, Ping Wang
The nonstationarity of the real interest rate has long been an important issue, both for monetary and fiscal policy and for financial theory. West (1988), for example, shows that an interest rate smoothing monetary policy leads to nonstationarity in the real interest rate in the context of an overlapping wage-contract model, while DeLong and Summers (1986) show that a similar effect is produced by nonstationary shocks to aggregate demand. Such nonstationarity is also inconsistent with the Black-Scholes option pricing assumption of a constant ex-ante real rate, and it would also lead to a rejection of the consumption-based CAPM (Rose, 1988). While Fama (1975) provided evidence that the U.S. ex-ante real interest rate was constant in his influential study of the efficiency of the Treasury bill market, this has since been shown to be almost certainly due to his choice of a 1953 to 1971 sample period. Indeed, most subsequent research has found against a constant real interest rate in favour of nonstationarity (see, for example, Rose, 1988).



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This paper forms part of the ESRC funded project (Award No. L1382511013) “Business Cycle Volatility and Economic Growth: A Comparative Time Series Study”, which itself is part of the Understanding the Evolving Macroeconomy Research programme.


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