Expectations and the Neutrality of Interest Rates

John H Cochrane

RBA Annual Conference Papers from Reserve Bank of Australia

Abstract: Our central banks set interest rate targets, 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 quite limited power to lower inflation. Empirical understanding of how interest rates affect inflation without fiscal help is also a wide-open question.

Keywords: inflation; fiscal theory of the price level; fiscal policy and inflation; interest rate theory; adaptive expectations models (search for similar items in EconPapers)
Date: 2023-11
New Economics Papers: this item is included in nep-ban, nep-mac and nep-mon
Note: Paper presented at the RBA's annual conference 'Inflation', Sydney, 25–26 September 2023.
References: View references in EconPapers View complete reference list from CitEc
Citations:

Downloads: (external link)
https://www.rba.gov.au/publications/confs/2023/pdf ... ce-2023-cochrane.pdf (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:rba:rbaacp:acp2023-07

Access Statistics for this paper

More papers in RBA Annual Conference Papers from Reserve Bank of Australia Contact information at EDIRC.
Bibliographic data for series maintained by Paula Drew ().