Abstract

General Equilibrium Models of Inflation and Interest Rates: Specification Considerations

The usual procedure in general equilibrium models is to invoke Walras’s Law to “eliminate” one market. As a methodological matter, the Tobin / Patinkin method is to model their respective general equilibrium frameworks by formally considering all markets. In this paper, four general equilibrium models of expected inflation and real interest rates are investigates in terms of their specification and consistency using the Tobin / Patinkin methodological procedure. A price expectations augmented Patinkin model reported earlier by the author is shown to be consistent. An increase in inflationary expectations may cause the real rate to rise or fall. When the Fisher effect holds in the bond market, the real rate must rise. The models of Mundell, Sargent, and Obst / Rasche do not include a bond market. Using the Tobin / Patinkin methodological procedure, if abond market incorporating all of the variables in the goods and money markets is included, no equilibrium occurs in any of those models. That is, the models are inconsistent; they are misspecified. Respecifying each market to include inflationary expectations as an independent influence results in a unique equilibrium in each model. For both the respecified Mundell and Obst / Rasche models, the real rate may rise or fall when expectations of inflation increase. If the Fisher effect holds in the bond market, the real rate must rise. For the respecified Sargent model, the real rate increases whenever inflationary expectations increase.