Working Paper: NBER ID: w0723
Authors: Maurice Obstfeld
Abstract: This paper examines the short-run relation between anticipated inflation and the real rate of interest in a model where agents with perfect foresight maximize utility over infinite lifetimes. In addition to deriving behavioral functions from explicit intertemporal optimization, the approach taken here departs from the usual IS-LM analysis in that it is dynamic and deals with a small economy open to trade in consumption goods. Because capital mobility must be ruled out to allow scope for variation in the real interest rate, the results obtained here for one of the two exchange- rate regimes considered -- free floating -- apply equally to a closed economy. The paper shows that an increase in the expected inflation rate depresses the real interest rate in the short run when the exchange rate is instantaneously fixed by the central bank. When equilibrium is determinate in the floating-rate case, the real interest rate is invariant with respect to inflation.
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Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| expected inflation rate (E31) | real interest rate (E43) |
| expected inflation rate (E31) | desired real balances (E41) |
| real interest rate (E43) | inflation (E31) |
| Mundell effect (F32) | real return on productive non-money assets (G19) |