Ambrose, John Charles
(1990)
Inflation, interest rates and transaction costs: The U.S. experience, 1953-1979.
MPhil thesis, London School of Economics and Political Science.
Abstract
This thesis contains three primary aspects: an analysis of the actual inflation-interest rate relationship in the American economy for the 1953-1979 and 1953-1983 periods in both the short-run and the long-run, a description and analysis of the failure of other real interest rate models to adequately account for the apparent failure of a "full" Fisher effect to operate, and empirical tests of a model (with some variations of it as well) which sheds light on the phenomenon of the underadjustment of nominal rates to inflation even when the longest of runs is taken into account. The essential notion underlying the model is that highly marketable financial assets yield liquidity services in the sense that the holding of them allows an agent to reduce his transactions costs of exchange. Given that the real return on money, which possesses ultimate liquidity, is the negative of the inflation rate then it follows that the real returns on assets which are relatively close to money in terms of liquidity services yielded by them should also fall in the face of increased inflation. The degree to which the real return on any particular asset declines is positively related to its 'moneyness'. Thus the returns on the longer term, relatively illiquid financial assets should be more subject to a full Fisher effect than those on the more marketable assets. The first chapter reviews some of the theoretical and empirical work on the Fisher effect and offers a detailed explanation of the basic model. An appendix deals with a transactions cost model of underadjustment which has a more explicit role for trading costs. Chapter 2 presents the empirical evidence on underadjustment in the short and long runs and critically reviews some work of others attempting to account for a less than complete Fisher effect. Chapter 3 deals with direct tests of the model's more important implications concerning the degree of adjustment of nominal rates to inflation with respect to an asset's liquidity. In Chapter 4 the hypothesis is entertained and empirically tested that some unexplained 'excess returns' found by researchers of the asset pricing model of security returns represent liquidity premia of the type dealt with in the model. Finally, Chapter 5 summarizes some of the thesis' more important conclusions.
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