JUHA J UN'I-FILA Universityof oulu Univeraty Of Oulu, Finland Testing an Augmented Fisher Hypothesis for a Small Open Economy: The Case of Finland* We augment the famous Fisher hypothesis for a small open economy by introducing foreign interest rate and exchange variables to the traditional test equation of the hypothesis. Using the Johansen cointegration method for the Finnish money market interest rate data we find that it is possible to find a positive long-run relationship between nominal interest rates and inflation. We also find that for a small open economy, like Finland, the effects from the corresponding markets of its main foreign trade partners are important when analyzing single macroeconomie hypotheses, like the Fisher hypothesis. 1. Introduction The formation of interest rates and their relation to other economic variables, like the domestic inflation rate has been among the most important and frequently examined questions in macroeconomics. Recently in Europe, where the attempt to foster greater integration of economies within the European Union in terms of the European Monetary Union (EMU) is the key issue in the political discussions at the international level, the question of the degree of international financial market dependencies has grown in importance, too. Recent studies on the integration within the European capital markets and with respect to other world markets, especially the U.S. market, have usually utilized time series analytical methods on examining certain interest rate parities, like the uncovered interest parity for nominal rates or the real interest parity. In many of these papers unit root econometrics has been the key empirical method in the analysis. Examining the causal relations between real interest rates for seven industrialized countries (Canada, France, Ger- many, Italy, Japan, the U.K. and the U.S.), using data for 1974--1992 Fujihara and Mougou6 (1995) found that the development in the German market has *I wish to thank Kajal Lahiri, Pekka Ilmak-unnas, Markku Laune, Markku Rahiala, Erkki Koskela, Rauli Svento and two anonymous referees for usefixl comments on earlier versions of this paper. I am also grateful to Kari Takala at the Bank Finland for providing me the data, and to the Finnish Postgraduate Program in Economics and the Research Foundation of the OKO- Bank group for financial support. Journal of Macroeconomics, Fall 2001, Vol. 23, No. 4, pp. 577-599 Copyright © 2001 by Louisiana State University Press 0164-0704/2001/$1.50 577