Edirisinghe, NavodaSivarajasingham, SelliahNigel, John2025-11-072025-11-072013Peradeniya Economic Research Symposium (PERS) -2013, University of Peradeniya, P 6-10https://ir.lib.pdn.ac.lk/handle/20.500.14444/6288Introduction: Maintaining price stability is one of the primary objectives of monetary policy in any economy. Because, price instability particularly high inflation, will cause economic growth to reduce, by reducing investments and productivity. Since, interest rates are one of the main channels that monetary policy uses to achieve the above goal, it is important to understand the relationship between interest rates, inflation and expected inflation. The “Fisher Hypothesis” and “Price Puzzle” provide the theoretical basis for these relationships. Fisher (1930) postulates that there is a one-to-one relationship between the nominal interest rate and expected inflation and assumes a constant real interest rate over the long-run. The Fisher hypothesis continued to generate a series of debates among economists. In the Fisher hypothesis the real interest rate is basically determined by real factors of the economy. This implies that the monetary policy measures are less effective to influence the real interest rate. On the other hand, Price puzzle simply states the positive relationship between nominal interest rate and inflation. According to the conventional view of monetary policy transmission mechanism there should be a negative association between nominal interest rates and inflation.This dynamic relationship between nominal interest rate and inflation will enable policy makers to conceive the nature, extent and dynamics of effective monetary policy. Cooray (2002) identified some evidence for Fisher relationship in Sri Lanka. The final conclusion of that study is, the market is likely make systematic mistakes in predicting the actual rate of inflation. Moreover, Jayasinghe and Udayaseelan (2008) have done an empirical study about the Fisher Effect in Sri Lanka. According to that study, monthly and quarterly data clearly display the absence of a long-term Fisher relationship in financial markets of Sri Lanka and annual data during the period 1953-1977 provide some evidence for such a relationship. Furthermore, Javid and Munir (2011) have done an empirical study to address the issue of monetary policy effectiveness and the price puzzle in Pakistan economy. The main findings of this study suggest that a positive interest rate shock (contractionary monetary policy) leads to persistent rise in the price level over a 48-month horizon.en-USFisher EffectPrice PuzzleCo-integrationError Correction ModelArticle