The effect of inflation on interest rates

This thesis addresses the effect of expected inflation on interest rates, and in so doing attempts to., replicate the findings of John Makin. In order to obtain an unbiased estimate of the effect of expected inflation on interest rates, other variables, such as inflation uncertainty, Federal budget deficits, the state of the business cycle and Federal Reserve policy, were included in the model. The model is a reduced form, modified IS-LM macroeconomic model with a money sub-model to separate expected from unexpected monetary policy. The regressions showed that a 1% change in expected inflation causes about a .915% change in short-term Treasury Bill yields; however, the results depend on the sample period and heteroscedasticity .correction employed. The point estimate of .915 for the expected inflation coefficient is similar to what many researchers have estimated. The coefficients for inflation uncertainty, the Federal budget deficits, and the business cycle were not significant. The attempt to replicate the results of John Makin was not successful. The R ² and coefficients for expected inflation and inflation uncertainty were different; however, the coefficients for unexpected monetary policy and the intercept term were quite similar.