In: Inflation: Causes and Effects ISBN: 978-1-60741-823-8 Editor: Leon V. Schwartz, pp. - © 2009 Nova Science Publishers, Inc. Chapter 3 THE NONPARAMETRIC TIME-DETRENDED FISHER EFFECT Heather L. R. Tierney ABSTRACT This paper uses frontier nonparametric VARs techniques to investigate whether the Fisher Effect holds in the U.S. The Fisher Effect is examined taking into account structural breaks and nonlinearities between nominal interest rates and inflation, which are trend-stationary in the two samples examined. The nonparametric time-detrended test for the Fisher Effect is formed from the cumulative orthogonal dynamic multiplier ratios of inflation to nominal interest rates. If the Fisher Effect holds, this ratio statistically approaches one as the horizon goes to infinity. The nonparametric techniques developed in this paper conclude that the Fisher Effect holds for both samples examined. Keywords: Fisher Effect, nonparametrics, dynamic multipliers, monetary policy, trend- stationarity. JEL Classification Code: E40, E52, E58 1. INTRODUCTION The dynamics of nominal interest rates and inflation are fundamental forces at the core of economic and financial decisions. The Fisher Effect, which relates these two variables, has several consequences on market rationality and efficiency, option pricing, portfolio allocation, monetary policy, and international trade just to name a few illustrations. 1 1 The Fisher Effect is a theoretical proposition based on the Fisher Equation, which defines nominal interest rates as being equal to the ex ante real interest rate plus expected inflation. According to the Fisher Effect in the long run, the real interest rate is constant, which means that there should be a long run one-to-one relationship between inflation and nominal interest rates that is referred to as the Fisher Hypothesis.