Inflation indicate to rise in
the general price level. High inflation rate increases the problem for both
developed and developing countries. Due to high inflation aggregate demand and
output, reduce unemployment increase, extend trade deficits and decline balance
of payment. High inflation and high interest rate hamper economic growth by
stoping investment and reducing the productivity of the country. Central bank
control inflation by interest rate channel and credit channel, controlling the
money supply through different instruments of monetary policy. The success of
monetary policy is based on the relationship between the interest rate in the
economy. Central bank control money supply through channel of interest rate by
deficit financing or by open market operations. The relationship between
interest rates, money supply and inflation rate is very important for a central
bank to regulate effective monetary policy.
Irving Fisher state that percentage change in expected inflation will cause a
percentage change in nominal interest rate. Fisher theory was examined very
important to implications of monetary policy. Gaul and Ekinci found a long run
relationship between nominal interest rate and inflation in turkey by applying
Johansen cointegrating technique unidirectional relationship which runs from
interest rates to the inflation rate. The Fisher (1930) equation is one of the
oldest and simplest ways to model the relationship between nominal interest
rates and inflation or purchasing power of money. The theoretical equation of
Fisher (1930) hypothesized that the nominal rate of interest (i) is made up of
two components: the real rate of return (r) and the expected rate of inflation (πe)
i = r + π
In a study by Fama (1975) on the reliability of the Fisher relationship between
the United States, his dual tests of market efficiency and the hypothesis that
the expected real return on the treasury bill is constant confirms the Fisher
relationship. His results suggest that variation in nominal interest rates fully
reflects the inflation expectation and nominal interest rates can be used as
proxies for expected inflation.
Shabbir (2010), tests the existing of a Fisher relationship in two oil-producing
and four South
Asian countries. The available series of interest rates involved in this study
are the government bond rate, call money rate, deposit rate, money market rate,
treasury bill rates and bank rate. The data span the period from 1971 until
2006. Using the ARDL estimation method, he finds the presence of the Fisher
effect in a weak form in Pakistan, Kuwait, Saudi Arabia, and India. However, no
Fisher relationship has been found in Bangladesh and in Sri Lanka.