Fisher Effect in Pakistan

Hamid Hasan


This paper attempts to test the validity of the Fisher
Hypothesis (FH) in Pakistan by investigating the long-run relationship
between interest rate and inflation rate applying cointegration
analysis. The FH has serious implications for debtors and creditors in
an inflation prone economy since inflationary expectations influence
nominal interest rate. Moreover, the effectiveness of monetary policy
and efficiency in banking sector has direct bearing on the long-run
relationship between nominal interest rate and expected inflation rate.
Inflationary expectation has been modeled using adaptive and rational
expectation approaches and sensitivity of the result to expectation
formation has been compared. The paper finds the long-run relationship
between nominal interest rate and inflation rate and accepts the partial
Fisher Hypothesis. This result suggests that interest rate does not
fully cover or accurately anticipate inflation, which implies that bank
deposits deteriorate over time. The result further implies that monetary
policy may not be effective in such a situation and households’ savings
rate may suffer a decline. The acceptance of partial Fisher Hypothesis
in case of rational expectation suggests that the rate of interest does
not reflect all relevant information and real interest rate does not
exhibit random walk behaviour, which is indicative of inefficiency in
banking sector. The analysis clearly shows the failure of interest rate
as a hedge against inflation and as a predictor of inflation. Therefore,
the paper recommends innovation and financial engineering for better
alternative especially in banking. The paper also recommends the growth
and encouragement of equity market vis-à-vis prevalent debt-biased
market. Finally, the paper advocates the complete replacement of
traditional credit-based banking by more efficient trade-based banking
in Pakistan.

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