The puzzling unit root in the real interest rate and its inconsistency with intertemporal consumption behavior

Previous studies of real interest rates generally have great difficulty rejecting unit-root dynamics, especially for industrial countries. The apparent unit-root behavior is puzzling because it contradicts both standard intertemporal asset pricing models and the Fisher effect. In examining international data for both industrial and developing countries, this study uncovers new evidence supporting the Fisher effect. It shows that structural change in real interest rate dynamics can be responsible for the observed unit-root behavior. When a mean shift is permitted under the alternative hypothesis, strong evidence against unit-root dynamics is unveiled for both industrial and developing countries. The cross-country findings provide wide support for the Fisher effect and resolve the puzzling inconsistency with intertemporal consumption behavior.