Frederick Mishkin's work has been dedicated to understanding the relationship between money, interest rates and inflation. The 15 essays in this collection - unabashedly empirical and rigorous - include much of Professor Mishkin's most highly regarded work. Money, Interst Rates and Inflation offers a coherent and informative assessment of how monetary policy affects the economy. In addition, the essays in this collection illustrate how rational expectations econometrics can be used to answer basic questions in the monetary-macroeconomics and finance areas.

This paper sheds light on a narrow but crucial question in finance: What should be the parameters of a model of the short-term real interest rate? Although models for the nominal interest rate are well studied and estimated, dynamics of the real interest rate are rarely explored. Simple ad hoc processes for the short-term real interest rate are usually assumed as building blocks for more sophisticated models. In this paper, parameters of the real interest rate model are estimated in the broad class of single-factor interest rate diffusion processes on U.S. monthly data. It is shown that the elasticity of interest rate volatility—the relationship between the volatility of changes in the interest rate and its level—plays a crucial role in explaining real interest rate dynamics. The empirical estimates of the elasticity of the real interest rate volatility are found to be about 0.5, much lower than that of the nominal interest rate. These estimates show that the square root process, as in the Cox-Ingersoll-Ross model, provides a good characterization of the short-term real interest rate process.

We study how differences in beliefs about expected inflation affect the nominal term structure when investors have “catching up with the Joneses” preferences. In the model, “catching up with the Joneses” preferences help to match the level and slope of yields as well as the level of yield volatilities. Disagreement about expected inflation helps to match the dynamics of yields and yield volatilities. Expected inflation disagreement induces a spillover effect to the real side of the economy with a strong impact on the real yield curve. When investors share common preferences over consumption relative to the habit with a coefficient of relative risk aversion greater than one, real average yields across all maturities rise as disagreement increases. Real yield volatilities also rise with disagreement. To develop intuition concerning the role of different beliefs between investors, we consider a case where the real and nominal term structures can be computed as weighted-averages of quadratic Gaussian term structure models. We numerically find increased disagreement about expected inflation between the investors increases nominal yields and nominal yield volatilities at all maturities. We find empirical support for these predictions.

This paper provides empirical evidence on the information in the term structure for longer maturities about both future inflation and the term structure of real interest rates. The evidence indicates that there is substantial information in the longer maturity term structure about futureinflation: the slope of the term structure does have a great deal of predictive power for future changes in inflation. On the other hand, at the longer maturities, the term structure of nominal interest rates contains very little information about the term structure of real interest rates. These results are strikingly different from those found for very short-term maturities, six months or less, in previous work. For maturities of six months or less, the term structure contains no information about the future path of inflation, but it does contain a great deal of information about the term structure of real interest rates. The evidence in this paper does indicate that, at longer maturities, the term structure of interest rates can be used to help assess future inflationary pressures: when the slope of the term structure steepens, it is an indication that the inflation rate will rise in the future and when the slope falls, it is an indication that the inflation rate will fall. However, we must still remain cautious about using the evidence presented here to advocate that the Federal Reserve should target on the term structure in conducting monetary policy. A change in Federal Reserve operating procedures which focuses on the term structure may well cause the relationship between the term structure and future inflation to shift, with the result that the term structure no longer remains an accurate guide to the path of future inflation. If this were to occur, Federal Reserve monetary policy could go far astray by focusing on the term structure of interest rates.