RDP 9104: Cross-Country Relationship Between Interest Rates and Inflation over Three Decades 5. Conclusion

Although it is relatively well known that nominal interest rates tend to be higher in high inflation countries, it is less well known that in recent years, such countries have also tended to have higher short-term real interest rates. This paper used graphs and some simple regressions to establish the positive relationship between short-term real interest rates and inflation over the second half of the 1980s. It then attempted to explain why this has been the case.

The paper suggested two reasons why real short-term interest rates might be higher in high inflation countries and attempted to determine which of these two hypotheses might be correct. Unfortunately, the simple test used was unable to lend support to either hypothesis.

The graphical analysis also established that the relationship between real interest rates and inflation across countries has changed since the 1970s. The positive relationship referred to above only began to show up in the 1980s. Deregulation was advanced as one reason why the relationship between short-term real interest rates and inflation altered in the 1980s. But another explanation was simply that inflationary expectations adjusted slowly to the high inflation environment of the 1970s. The paper came to no conclusion on which of these explanations is more likely to be correct.