1 Nonlinear Relation of Inflation and Nominal Interest Rates – A Local Nonparametric Investigation Marcelle Chauvet and Heather L. R. Tierney * Abstract This paper investigates the relationship between nominal interest rates and inflation in the U.S. in the last 50 years. In particular, we use a recursive framework in which all model parameters are time varying, not only across sub-samples, but at any point in time. This allows examination of potential structural breaks in inflation response to monetary shocks as well as systematic changes over the business cycle. Our goal is to study not only if monetary policy and inflation coefficients have changed over time, but also if they change across the state of the economy, or when inflation is in a high or low growth phase. We propose a nonparametric tool to investigate local dynamic impulse response functions in a VAR system. The advantage of this tool is that it allows analysis – at each iteration – of the local average effects of a shock to any given variable in the VAR system. In addition, potential nonlinearities, nonstationarities, and asymmetric behavior can be examined without the need for specifying a functional form, and information in the tail regions can be incorporated in the model. We use this framework to shed light into the potential nonlinear dynamics of inflation and interest rates. KEY WORDS: Inflation, nominal interest rates, vector autoregression, nonparametric, monetary policy. JEL Classification: E40, E52, E58 ∗ Marcelle Chauvet, Department of Economics, University of California, Riverside, CA 92521-0247; chauvet@ucr.edu . Heather L.R. Tierney, Department of Economics and Finance, College of Charleston, 5 Liberty Street, Charleston, SC, 29424; tierneyh@cofc.edu .