John Merrick's critique of my 1977 study of real interest rate movements rests on two grounds. The criticism that occupies most of his attention is concerned with whether my model remains internally consistent when either of the two models of inflationary expectations are added to the macro-economic models of the real rate of interest. Merrick finds that each of my macroeconomic models of the real rate has embedded in it a model of inflationary expectations when rational expectations are applied to it, so that my procedure of adding alternative models of inflationary expectations to each macro-economic structure produces a misspecification of the models and constitutes a fundamental flaw in

At least since the time of Irving Fisher, it has been clear that nominal rates of interest differ from real rates not because of current or past price level changes but because of expected future price level changes. Accordingly, while nominal rates of return on fully discounted notes are observable magnitudes, expected real returns on the same notes are nonobservable. Nevertheless, real rates of return and real rates of interest are important concepts in the development of contemporary macroeconomic theory, particularly so as that theory develops richer theoretical roles for real rate and inflationary expectations measures. Furthermore, questions such as whether real rates are constant over time or are subject to systematic fluctuation through time reflect attributes of financial behavior that have important implications for understanding macroeconomic adjustment mechanisms. Even so, little attention has been given to the problem of forming and evaluating empirical measures of temporal movements in real rates of interest.' The work done by Fisher and several contemporary followers has proceeded on the premise the expected real rates of interest are constant over time. This theory has usually been examined empirically by estimating a model of the form:2