Research / BFI Working PaperFeb 01, 2016

Do Higher Interest Rates Raise or Lower Inflation?

The standard “new-Keynesian” model accounts well for the fact that inflation has been stable at a zero interest rate peg. However, if the Fed raises nominal interest rates, the same model predicts that inflation will smoothly rise, both in the short run and long run. This paper presents a series of failed attempts to escape this prediction. Sticky prices, money, backward-looking Phillips curves, alternative equilibrium selection rules, and active Taylor rules do not convincingly overturn the result. The evidence for lower inflation is weak. Perhaps both theory and data are trying to tell us that, when conditions including adequate fiscal-monetary coordination operate, pegs can be stable and inflation responds positively to nominal interest rate increases.