CHAPTER 5

The Behaviour of Interest Rates

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us which one of the two scenarios, panel (b) or panel (c) of Figure 5-12, is more
accurate. It depends critically on how fast people s expectations about inflation
adjust. However, recent research using more sophisticated methods than just looking at a graph like Figure 5-13 do indicate that increased money growth temporarily lowers short-term interest rates (this is also indicated in Figure 5-13 in the
2000s).7 However, as you can see in the FYI box Forecasting Interest Rates, interest rate forecasting is a perilous business.

Forecasting Interest Rates

FYI

Forecasting interest rates is a time-honoured
profession. Economists are hired (sometimes
at very high salaries) to forecast interest rates
because businesses need to know what the
rates will be in order to plan their future
spending, and banks and investors require
interest-rate forecasts in order to decide
which assets to buy.
The media frequently report interest rate
forecasts by leading prognosticators. These
forecasts are produced using a wide range of
statistical models and a number of different
sources of information. One of the most popular methods is based on the bond supply
and demand framework described earlier in
the chapter. Using this framework, analysts
predict what will happen to the factors that

affect the supply of and demand for bonds
and then use the supply and demand analysis outlined in the chapter to come up with
their interest-rate forecasts.

7

An alternative method of forecasting
interest rates makes use of econometric models, models whose equations are estimated
with statistical procedures using past data.
Many of these econometric models are quite
large, involving hundreds and sometimes
over a thousand interlocking equations. They
produce simultaneous forecasts for many
variables, including interest rates, under the
assumption that the estimated relationships
between variables do not change over time.
Good forecasts of future interest rates are
extremely valuable to households and businesses, which, not surprisingly, would be
willing to pay a lot for accurate forecasts.
Unfortunately, forecasting interest rates is a
perilous business. To their embarrassment,
even the top experts are frequently far off in
their forecasts.

See Lawrence J. Christiano and Martin Eichenbaum, Identification and the Liquidity Effect of a Monetary
Policy Shock, in Business Cycles, Growth, and Political Economy, ed. Alex Cukierman, Zvi Hercowitz,
and Leonardo Leiderman (Cambridge, Mass.: MIT Press, 1992), pp. 335 370; Eric M. Leeper and David B.
Gordon, In Search of the Liquidity Effect, Journal of Monetary Economics 29 (1992): 341 370; Steven
Strongin, The Identification of Monetary Policy Disturbances: Explaining the Liquidity Puzzle, Journal
of Monetary Economics 35 (1995): 463 497; Adrian Pagan and John C. Robertson, Resolving the Liquidity

Effect, Federal Reserve Bank of St. Louis Review 77 (May June 1995): 33 54; and Ben S. Bernanke and
Illian Mihov, Measuring Monetary Policy, Quarterly Journal of Economics 63 (August 1998): 869 902.