Whether Interest Rates are the Most Significant Drivers of Inflation

Weijia Jia ()
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Weijia Jia: University of Hong Kong

A chapter in Proceedings of the 2025 7th International Conference on Economic Management and Cultural Industry (ICEMCI 2025), 2025, pp 502-510 from Springer

Abstract: Abstract The effectiveness of interest rate policy in controlling inflation has long been a foundational assumption in macroeconomic theory and central banking for a long time. However, the relative importance of interest rates as compared to other macroeconomic variables remains an empirical question of debate, especially for the recent monetary regimes and inflation shocks. This paper aims to examine whether interest rates are the most significant factor influencing inflation, or whether other variables, namely money supply and real economic activity play a more important role. Using monthly panel data from two countries between January 2014 and November 2019, both single and multiple linear regression models are conducted to evaluate the impact of nominal interest rates, broad money supply (M2), and real GDP index on inflation. The results indicate that, although interest rates exhibit the expected negative relationship with inflation, money supply emerges as the most statistically and economically significant explanatory variable. The preferred model achieves an adjusted R2 of 0.611, with all three variables contributing to explanatory power, but with money supply exerting the strongest marginal effect. These findings challenge the conventional emphasis on interest rate-centric policy regimes and suggest that a broader monetary framework, accounting for liquidity conditions and monetary aggregates, is essential for understanding and managing inflation dynamics. These results offer valuable insights for policymakers seeking to preserve price stability in dynamic economic environments.

Keywords: Inflation; Interest Rate; Monetary Policy (search for similar items in EconPapers)
Date: 2025
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Persistent link: https://EconPapers.repec.org/RePEc:spr:advbcp:978-94-6463-888-2_49

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DOI: 10.2991/978-94-6463-888-2_49

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