Working Paper: NBER ID: w30468
Authors: John H. Cochrane
Abstract: Our central banks set interest rates, and do not even pretend to control money supplies. How do interest rates affect inflation? We finally have a complete theory of inflation under interest rate targets and unconstrained liquidity. Its long-run properties mirror those of monetary theory: Inflation can be stable and determinate under interest rate targets, including a peg, analogous to a k-percent rule. The zero bound era is confirmatory evidence. Uncomfortably, stability means that higher interest rates eventually raise inflation, just as higher money growth eventually raises inflation. Sticky prices generate some short-run non-neutrality as well: Higher nominal interest rates can raise real rates and lower output. A model in which higher nominal interest rates temporarily lower inflation, without a change in fiscal policy, is a harder task. I exhibit one such model, but it paints a much more limited picture than standard beliefs. We either need a model with a stronger effect, or to accept that higher interest rates have limited power to lower inflation. Empirical understanding of how interest rates affect inflation without fiscal help is also a wide-open question.
Keywords: No keywords provided
JEL Codes: E4; E5
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Higher nominal interest rates (E43) | Higher inflation (E31) |
| Higher nominal interest rates (E43) | Expected inflation (E31) |
| Higher interest rates (E43) | Higher inflation (E31) |
| Higher interest rates alone may not suffice to reduce inflation without fiscal tightening (E62) | Higher inflation (E31) |
| Fiscal policy actions (E62) | Higher inflation (E31) |