The Relationship Between Nominal Interest Rates and Inflation: The Short Run

The conventional view of monetary policy highlights the short- and intermediate-run relationship between nominal interest rates and inflation. Namely that they are inversely related. This negative or inverse relationship is related to the "liquidity effect". The liquidity effect refers to the mechanism through which decreases (increases) in the policy rate are achieved by monetary injections (contractions) via open market purchases (sales), i.e. adding (subtracting) liquidity moves the interest rate in the opposite direction. The resulting decline (increase) in real interest rates, a consequence of inflation inertia, lead to greater (lesser) economic activity by altering consumption, through the intertemporal substitution effect, and investment, through a cost of capital effect. Eventually the increase (decline) in economic activity results in higher (lower) inflation via the Phillips curve relationship. So the conventional view of monetary policy is that decreases in the policy rate lead to greater economic activity and higher inflation while increases should eventually lead to lower activity and lower inflation.

This relationship is highlighted in Taylor-type monetary policy rules such as equation (1), \begin{equation*} i_t = r + \pi^* + \xi_y (Y_t - Y^*) + \xi_{\pi} (\pi_t - \pi^*)\tag{1}\end{equation*} where \(i_t\) is the policy rate that responds positively when output, \(Y_t\), or inflation, \(\pi_t\), are above their targeted values, \(Y^*\) and \(\pi^*\), respectively, and negatively when either are below target. When combined with a Phillips curve like equation (2), \begin{equation*} \pi_t = \zeta E_t \pi_{t+1} -\eta (U_t - U^*) \tag{2}\end{equation*} where \(U_t\) is the unemployment rate and \(U^*\) is the natural or equilibrium rate of unemployment, or a New Keynesian Phillips curve relationship like (3), \begin{equation*} \pi_t = \gamma E_t \pi_{t+1} + \kappa (Y_t - Y^*) \tag{3}\end{equation*} and some type of IS relationship like \begin{equation*} Y_t - Y^* = -\sigma (r_t - r^*) \tag{4}\end{equation*} we get the conventional monetary policy result. When output is below target (or equivalently unemployment is above the natural rate) we can trace the conventional monetary policy causal chain as something like \(i_t \downarrow \rightarrow r_t \downarrow \rightarrow Y_t \uparrow \text{and/or}\; U_t \downarrow \rightarrow \pi_t \uparrow\). The implication is that in the short-run the nominal interest rate causes or leads inflation.