Abstract

The objective of this study is to test the relationship between short-term nominal interest rate and inflation in the context of the Indian financial market.  To achieve this objective we perform Augmented Dickey-Fuller unit root test to check for stationarity and thereafter we test for co-integration using the Engle-Granger method and further corroborate the findings of this test with the Johansen-Juselius method.  Lastly, we perform the Granger causality test.  Monthly data of inflation and nominal short term interest rates for the period from April 1996 to August 2004 were used.  We find that expected inflation and nominal short-term interest rates are co-integrated in the Indian context. Thus, the present study doesn’t reject the Fisher effect in the Indian financial market.  This test shows that expected inflation is Granger caused by nominal short term interest rates. These findings are important in the context of financial market policies in emerging economies like India.

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