The Peculiar Relationship of the Interest rate and the Rate of Inflation

Today’s post is going to be about the impact of the interest rate on the rate of inflation. This is because I stumbled across this twice today. In one of my Economics classes my professor claimed that higher interest rates lead to higher rates of inflation while in my Macroeconomics class which teaches the Liquidity Preference Model and the AD/AS Model it would be that higher interest rates lead to lower rates of inflation in the short run. So let’s shed light on their relationship.

First, let’s revisit the standard Macroeconomics Liquidity Preference and AD/AS Model. Taken together they provide the conventional answer how changes in the money supply affect the economy in the short run as well as in the long run. It is also called the money transmission mechanism. Consider what happens if the Central Bank decides to increase the interest rate. In order to do so it can either engage in open market operations or set the official cash rate directly. However, both tools are equivalent in the Liquidity Preference Model with the outcome that interest rates rise and in response the demand for money (MD) falls. In the AD/AS Model the increase in the interest rate alters aggregate demand, because at least investment is negatively related to the interest rate. In particular, a rise in the interest rate decreases investment and shifts the AD curve to the left. As a result (1) output falls and (2) the price level falls. Hence an increase in the interest rate is expected to be deflationary in the short run. In the long-run, however, the demand for liquidity in the Liquidity Preference Model will adjust. Because the aggregate price level is lower people will demand less currency which shifts the MD curve downward and which causes the interest rate to return to its long-run steady state. Simultaneously, in the AD/AS Model the SRAS curve will shift as nominal wages adjust. As a result (1) output rises back to its initial level and (2) the price level falls further. Hence, in the long run inflation and interest rates fall in tandem.

In sum, an increase in the interest rate is predicted to lead to lower inflation in the short run. In the long run, however, the relationship is less clear if there is a relationship at all. This depends on what is happening in the AS/AD model, i.e. whether the economy shifted away from potential GDP or whether it shifted towards potential GDP because of the change in the interest rate and whether there is deliberate government intervention. While the interest rate will return to its long run steady state the price level might remain unchanged, increase again or decrease further.

Let’s contrast this with the Neo-Fisherian View and what it predicts what will happen to inflation when interest rates rise. After some research I found a great video by George Waters of Illinois State University on The Fisher relation and monetary policy from which I have taken the graph included below. The starting point is the so-called Fisher relation. It states that the real interest rate is equal to the nominal interest rate adjusted for (expected) inflation. Assuming that the real interest rate is stable in the short run one can rearrange the relation so that the nominal interest rate (i) equals the fixed real interest rate, which is practically a constant, plus inflation (π). Waters points out that the assumption of a fixed real interest rate is valid as long as savings behaviour and the returns to capital are stable in the short run. Because the real interest rate is held constant, one can draw the Fisher relation as an upward sloping line with the intercept being at the fixed real interest rate and a slope of 1, as shown in the diagram below.

Fisher relation
(Source: Waters, 2015)

So the diagram depicts essentially a positive relationship between the nominal interest rate and the rate of inflation. Hence in the Neo-Fisherian point of view an increase in the interest rate actually increases inflation. If this were to hold a Central Bank could raise inflation by raising the nominal interest rate rather than lowering it. This result stands in contrast with the predictions of the standard textbook Liquidity Preference and AD/AS Model which I presented before.

But which theory is right? Is it the classical Keynesians or the Neo-Fisherians? As Scott Sumner (2015) points out, probably “both sides are right, and both sides are wrong”. An argument for the Neo-Fisherians is that the nominal interest rate does indeed seem to match changes in trend inflation over any extended time period. An argument for the Keynesian view is that the money transmission mechanism acts as a signalling device, meaning that interest rate cuts signal an expansionary monetary policy and interest rate increases signal a contractionary monetary policy to the public (Sumner, 2015).

So where does this leave us with? There seems to be no clear-cut answer to the relationship of interest rates and the rates of inflation at the moment and with contradicting economic theories and empirical evidence leaning towards a positive relationship there will need to be more research in the future. As nominal interest rates currently hit the zero lower bound this will be an interesting debate to follow. Some researchers have taken it as a ‘natural experiment’ to explore essentially the impact of an interest rate peg at zero. There is an ongoing debate about the Neo-Fisherian idea in the blogosphere and there are new working papers coming out which now even include concepts like Behavioural Macroeconomics (Smith, 2015). For example, a more recent working paper by John Cochrane (2016) titled “Do Higher Interest Rates Raise or Lower Inflation?” makes the case for a positive relationship with only weak evidence for lower inflation…

Jasse


Cochrane, J.H. (2016). Do Higher Interest Rates Raise or Lower Inflation? [Pdf] Retrieved from http://faculty.chicagobooth.edu/john.cochrane/research/papers/fisher.pdf

Smith, N. (2015, July, 12). Woodford vs. the Neo-Fisherians. Retrieved from http://noahpinionblog.blogspot.co.nz/2015/07/woodford-vs-neo-fisherians.html

Sumner, S. (2015, May 19). Neo-Fisherism, missing markets, and the identification problem. Retrieved from http://www.themoneyillusion.com/?p=29429

Waters, G. (2015, July 31). The Fisher relation and monetary policy [YouTube Video]. Retrieved from https://www.youtube.com/watch?v=n8GAmiTGJII

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