Inflation Instability Impact on Interest Rate in Egypt: Augmented Fisher Hypothesis Test

Abstract

The paper aims at examining an augmented version of Fisher hypothesis that include inflation instability. According to this hypothesis, there is a positive relation between interest rates and expected inflation. In contrast, there is a debate regarding the impact of inflation uncertainty on interest rate. According to the portfolio theory and models of asset pricing, inflation instability positively affects the interest rate. The reason is that risk-averse investors must be compensated with higher returns for higher risks. In contrast, the loanable funds theory implies a negative impact of inflation instability and interest rates since high uncertainty leads consumers to protect themselves against inflation by raising their savings which lowers consumption and interest rates. To compute inflation volatility, we applied different Autoregressive Conditional Heteroscedasticity models. The simple and augmented versions of Fisher hypothesis are examined using Markov Switch Model to account for possible regime shift in that relationship. For the original Fisher hypothesis, there is an evidence of supporting it in the first regime while that hypothesis does not hold in the second one. In the augmented version of Fisher hypothesis, portfolio theory hypothesis is verified in the first regime whereas the loanable funds hypothesis is confirmed in the second one.