Real interest rates and shifts in macroeconomic volatility

A growing amount of research indicates that the relation between nominal interest rates and future inflation is country and period dependent. We investigate the relation between the short-term interest rate and inflation by means of an intertemporal consumption capital asset pricing model, resulting in a generalized Fisher equation in which the nominal interest rate is a function of inflation and the conditional variances of money growth and industrial production growth. The conditional variances are calculated using both the multi state Kalman filter model and the multivariate stochastic volatility model. These methods allow for occasional level shifts in our proxies for macroeconomic uncertainty. Our results indicate that it is important to incorporate monetary uncertainty represented by a proxy of the conditional variance of money growth to explain shifts in the real interest rate.