EH.Net Abstracts in Economic History

Expectations, Fisher's Hypothesis, and the Gibson Paradox:
Evidence from the British Consol Market, 1790-1825

              (c) 1997 EH.Net
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              Name:  Yona Rubinstein
               Email:  msyona at olive.huji.ac.il
         Institution:  Hebrew University  

         Co-author:  Nathan Sussman, The Hebrew University of
Jerusalem  

             Title:  Exchange Rate Regimes, Inflationary
Expectations, Fisher's Hypothesis, and the Gibson Paradox:
Evidence from the British Consol Market, 1790-1825  

  Internet Address
of abstracted work:  Not available on the Internet  

           By mail:  
                     Department of Economics
                     The Hebrew University of Jerusalem
                     Mt. Scopus, Jerusalem 91905
                     Israel
 
          Language:  English
 
          Abstract:
   One of the most persistent puzzles in monetary economics is
the positive correlation between interest rates and the price
level.	This empirical regularity--defined by Keynes as the
"Gibson Paradox"--seems to defy the Fisher hypothesis.	Numerous
empirical studies and theoretical suggestions have emerged to
reconcile this contradiction between economic theory and the data.

  In this paper we specify an Augmented Fisher Equation that
allows shocks and nominal rigidities, reflected in the market for
real balances, to affect the real interest rate and the long-run
anchors of the price level to affect the nominal component of the
interest rate.	In a classical fixed exchange rate regime the
money supply is endogenous, and the anchors of the long-run price
level are the exchange rate and the foreign price level.  In a
classical free float, the money supply is exogenous, and the
long-run price level is determined by the quantity theory.  Real
and nominal shocks will have a different effect on real balances
in the two monetary regimes.  Therefore, we expect them to have a
qualitatively different effect on the real interest rate.

  We test our Augmented Fisher Equation by selecting Britain in
the years 1797-1850.  During that period, a change in monetary
regimes and policy provides us with a unique "natural experiment"
to study the relationship between two classical monetary regimes
and the variables that make up our Augmented Fisher Equation.
Britain was forced, due to the Napoleonic Wars, to suspend gold
convertibility in 1797.  It maintained a free float until 1821.

  We show, using the Augmented Fisher Equation, that we can find
empirical evidence in support of Fisher's hypothesis.  We also
show that the Gibson effect is part and parcel of the Augmented
Fisher Equation and in no way constitutes a paradox.

  We find that the Gibson relationship is not limited to wartime
or war finance; on the contrary, the Gibson relationship is
stronger in the postwar era.  We also find that when we allow for
the effect of supply shocks, a positive correlation between the
price level and interest rates existed also in the suspension
era.  We find that the war raised the real interest rate by
roughly one percentage point.  However, we also find that the
Bank of England financed part of the war with inflation tax.
According to our results the increase in the real money supply of
5.5 percent per year contributed to a decline in the average real
interest rate throughout the war of about 0.5 percent.

  Our results provide evidence in support of the operation of the
fundamental long-run relationships of the PPP and the quantity
equation in their respective regimes during the nineteenth
century.  Results obtained from estimating the Augmented Fisher
Equation allow us to claim that British investors behaved in
accordance with the monetary regime; we cannot reject the
hypothesis that rational agents living at the time understood the
difference in the monetary regimes and the economic policy
pursued and formed their expectations accordingly.
 
      Bibliography:  Rubinstein, Yona, and Nathan Sussman.
"Exchange Rate Regimes, Inflationary Expectations, Fisher's
Hypothesis, and the Gibson Paradox: Evidence from the British
Consol Market, 1790-1825." Paper presented at the third World
Congress of Cliometrics, Munich, Germany, July 1997.
 
                  Subject:  H
 Geographical Area:  4
      Country/Region:  Great Britain
           Time Period:  7


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