Three ways to interpret the long-run Fisher relation: An extremely important question for the analysis of monetary policies

The long-run Fisher relation (expected inflation is equal to inflation in the long run) is written: Nominal interest rate = Real interest rate + Inflation There are three ways to interpret this long-run Fisher relation (we illustrate our analysis with the cases of the euro zone and Japan): The traditional way : inflation is determined by money supply growth; the real interest rate results from structural features of the economy (technological progress, potential growth); the nominal interest rate then results from the real interest rate and inflation determined this way . The problem with th is traditional way is that it is no longer consistent with the facts: there is no longer any correlation between money supply growth and inflation. The neo- Fisherian way : the central bank controls the nominal interest rate, which is consistent with the facts; like in the traditional approach, the real interest rate results from structural features of the economy; the nominal interest rate therefore determines inflation in the long run . This approach is very troubling, because it implies that a permanent fall in the nominal interest rate leads to lower inflation, when central banks use nominal interest rate cuts to lift inflation. A way that gets around neo- Fisherism , in which monetary policy has a permanent effect on the real interest rate: the central bank controls the nominal interest rate, but a permanent fall (for example) in the nominal interest rate leads to a fall in the real interest rate, which prevents it from leading to a fall in inflation. The mechanism may be as follows: the fall in the nominal interest rate leads to an increase in investment and in the capital intensity of the economy, leading to a fall in the marginal productivity of capital and in the real interest rate. This third interpretation offers a way around the neo- Fisherian critique, provided the fall in the real interest rate is sufficiently large.