Are nominal bonds appropriately discounted for taxes? Empirical estimates of the response of nominal interest rates to changes in inflation, the Fisher effect, have failed to produce a definitive answer. Four reasons have been put forward as possible explanations: (i) Tobin effects, (ii) fiscal illusion, (iii) peso problems, and (iv) different estimators. Utilizing data on taxable and tax‐exempt bond interest rates and several different estimators, we find that the Fisher effect estimates are always larger for the taxable bond relative to the tax‐exempt bond, suggesting that fiscal illusion and different estimators cannot account for the previous results.

This paper examines the roles played by innovations identified from a simple four-variable VAR characterized by cointegration. Using knowledge of cointegration rank and “textbook” relations that link macroeconomic aggregates, we identify distinct “real” and “nominal” innovations that dictate the long-run behavior of the model. We also examine the explanatory power of transitory innovations that are orthogonal to these permanent shocks. One of the permanent shocks displays all the characteristics of a technology or “supply” innovation, while one of the transitory innovations—identified by imposing short-run price rigid-ity—is interpretable as a “demand” side impulse. The permanent nominal shock bears the imprint of an innovation in aggregate inflation expectations. Historical decomposition and comparison with variables that are external to the model reveals the relative importance of the shocks at various episodes.

Are nominal bonds appropriately discounted for taxes? Empirical estimates of the response of nominal interest rates to changes in inflation, the Fisher effect, have failed to produce a definitive answer. Four reasons have been put forward as possible explanations: (i) Tobin effects, (ii) fiscal illusion, (iii) peso problems, and (iv) different estimators. Utilizing data on taxable and tax‐exempt bond interest rates and several different estimators, we find that the Fisher effect estimates are always larger for the taxable bond relative to the tax‐exempt bond, suggesting that fiscal illusion and different estimators cannot account for the previous results.