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Fisher Effect in Pakistan

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  • Hamid Hasan

    (International Institute of Islamic Economics, International Islamic University, Islamabad.)

Abstract

This paper attempts to test the validity of the Fisher Hypothesis (FH) in Pakistan by investigating the long-run relationship between interest rate and inflation rate applying cointegration analysis. The FH has serious implications for debtors and creditors in an inflation prone economy since inflationary expectations influence nominal interest rate. Moreover, the effectiveness of monetary policy and efficiency in banking sector has direct bearing on the long-run relationship between nominal interest rate and expected inflation rate. Inflationary expectation has been modeled using adaptive and rational expectation approaches and sensitivity of the result to expectation formation has been compared. The paper finds the long-run relationship between nominal interest rate and inflation rate and accepts the partial Fisher Hypothesis. This result suggests that interest rate does not fully cover or accurately anticipate inflation, which implies that bank deposits deteriorate over time. The result further implies that monetary policy may not be effective in such a situation and households’ savings rate may suffer a decline. The acceptance of partial Fisher Hypothesis in case of rational expectation suggests that the rate of interest does not reflect all relevant information and real interest rate does not exhibit random walk behaviour, which is indicative of inefficiency in banking sector. The analysis clearly shows the failure of interest rate as a hedge against inflation and as a predictor of inflation. Therefore, the paper recommends innovation and financial engineering for better alternative especially in banking. The paper also recommends the growth and encouragement of equity market vis-à-vis prevalent debt-biased market. Finally, the paper advocates the complete replacement of traditional credit-based banking by more efficient trade-based banking in Pakistan.

Suggested Citation

  • Hamid Hasan, 1999. "Fisher Effect in Pakistan," The Pakistan Development Review, Pakistan Institute of Development Economics, vol. 38(2), pages 153-166.
    • Handle: RePEc:pid:journl:v:38:y:1999:i:2:p:153-166
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    File URL: http://www.pide.org.pk/pdf/PDR/1999/Volume2/153-166.pdf
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    References listed on IDEAS

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    1. Pesando, James E, 1979. "On the Random Walk Characteristics of Short- and Long-Term Interest Rates in an Efficient Market," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 11(4), pages 457-466, November.
    2. Fama, Eugene F, 1975. "Short-Term Interest Rates as Predictors of Inflation," American Economic Review, American Economic Association, vol. 65(3), pages 269-282, June.
    3. Granger, C. W. J., 1981. "Some properties of time series data and their use in econometric model specification," Journal of Econometrics, Elsevier, vol. 16(1), pages 121-130, May.
    4. Thomas J. Sargent, 1972. "Anticipated Inflation and the Nominal Rate of Interest," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 86(2), pages 212-225.
    5. Stock, James H, 1987. "Asymptotic Properties of Least Squares Estimators of Cointegrating Vectors," Econometrica, Econometric Society, vol. 55(5), pages 1035-1056, September.
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    Cited by:

    1. Siffat Mushtaq & Abdul Rashid & Abdul Qayyum, 2012. "On the Welfare Cost of Inflation: The Case of Pakistan," The Pakistan Development Review, Pakistan Institute of Development Economics, vol. 51(1), pages 61-96.
    2. Mpho Bosupeng, 2015. "The Fisher Effect Using Differences in The Deterministic Term," International Journal of Finance, Insurance and Risk Management, International Journal of Finance, Insurance and Risk Management, vol. 5(4), pages 1031-1031.
    3. Bilal Raza & Khurram S Mughal, 2022. "Fiscal Determinants of Inflation in Pakistan," SBP Working Paper Series 108, State Bank of Pakistan, Research Department.
    4. S, Surayya, 2018. "Alternative Specifications of Fisher Hypothesis: An Empirical Investigation," MPRA Paper 90320, University Library of Munich, Germany.
    5. Bosupeng, Mpho, 2016. "The Effects of Chinese Interest Rates and Inflation: A Decomposition of The Fisher Effect," MPRA Paper 78160, University Library of Munich, Germany, revised 2016.
    6. Jalil, Abdul & Tariq, Rabbia & Bibi, Nazia, 2014. "Fiscal deficit and inflation: New evidences from Pakistan using a bounds testing approach," Economic Modelling, Elsevier, vol. 37(C), pages 120-126.
    7. Bosupeng, Mpho, 2016. "On The Fisher Effect: A Review," MPRA Paper 77916, University Library of Munich, Germany, revised 2016.

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