Working Paper: NBER ID: w2784
Authors: Robert B. Barsky; J. Bradford De Long
Abstract: We consider the puzzling behavior of interest rates and inflation in the United States and the United Kingdom between 1879 and 1913. A deflationary regime prior to 1896 was followed by an inflationary one from 1896 until the beginning of World War I; the average inflation rate was 3.8 percentage points higher in the second period than in the first. Yet nominal interest rates were no higher after 1896 than they had been before. This nonadjustment of nominal interest rates would be consistent with rational expectations if inflation were not forecastable, and indeed univariate tests show little sign of serial correlation in inflation. However, inflation was forecastable on the basis of lagged gold production. Investors' expectations of inflation should have risen by at least three percentage points in the United States between 1890 and 1910. We consider in an information processing context alternative ways of accounting for this failure of interest rates to adjust, for example the possible beliefs that increases in gold production might be transitory. We conclude that the failure of investors to exhibit foresight with regard to the shift in the trend inflation rate after 1896 is not persuasive evidence that investors were negligent or naive in processing information.
Keywords: Inflation; Interest Rates; Gold Standard; Fisher Effect
JEL Codes: E31; E43
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Higher inflation rates (E31) | Lack of adjustment in nominal interest rates (E43) |
| Increases in gold production (L72) | Expectations of inflation (E31) |
| Lack of correlation between inflation and interest rates (E43) | Implications for Fisher effect (E43) |
| Increases in gold production (L72) | Higher inflation rates (E31) |
| Forecastable inflation based on lagged gold production (E31) | Lack of adjustment in nominal interest rates (E43) |