Interest Rates and Inflation

Keith Rankin, 29 January 1999

rejoinder to the Reserve Bank's reply to my NZ Herald article "Could it be Keynesian theorists got it wrong?"


The relationship between interest rates and inflation rates is much more contentious than the Reserve Bank's corporate affairs manager Paul Jackman would have us believe.

In nineteenth century monetarist thought, it was believed that there was a direct functional relationship from the quantity of money (which was believed to be proportional to the quantity of specie - gold or silver coin - in circulation) to the price level. Following from that, rising interest rates and falling price levels were seen as being independent consequences of a policy to restrict the money supply.

In practice, the quantity of money cannot be restricted through controls of specie or any other form of money (such as M1 or M3). New forms of money are always created where there is an unsatisfied demand for money. It is however true that restrictive monetary policies increase the price of money (ie the interest rate).

Thus, if restrictive money policies are to be effective in lowering the price level, it has to be through a functional relationship from interest rates to prices. Indeed this is central to modern monetarism in general, and to the 1989 New Zealand Reserve Bank Act in particular.

Conventional economics texts (ie based on Keynesian, monetarist and neoclassical economics) give only one transmission mechanism from high world interest rates to low world prices; namely recession and its fellow traveller, unemployment. (I am considering world prices, in which there can be no exchange rate effects.)

It is accepted (but not well publicised) that there are also transmission mechanisms from high interest rates to rising prices. In essence, the argument is that interest rates represent the cost of capital and capital is, like labour, a "factor of production". From this viewpoint, interest rates have a direct influence on prices, much as wages do.

The net effect is that high interest rates create recession and unemployment which lead to less "demand inflation", while at the same time create higher costs which means more "cost inflation". The wider economic environment will determine which force dominates. We cannot make any analytical judgement, however, as to whether the net effect of any particular high interest policy has been to lower or to raise prices, unless we have a "counterfactual"; ie a clear idea of what inflation would have been in the absence of the policy.

The Schumpetarian theory gives us a counterfactual that is very different from the implicit counterfactual used by the Reserve Bank. This theory that emphasises the relationship between investment cycles (the 10 year Juglar Cycle) and growth, also sees prices as being highly correlated to the long-wave (50 year) Kondratieff Cycle. Hence during an upturn of the Juglar cycle and a downturn in the Kondratieff cycle, we would expect significant economic growth to coincide with falling prices. Thus, from a Schumpetarian point of view, the big question is "why did prices not fall in the last quarter of the 20th century". Paul Jackman has ignored my challenge to answer that question.

There are two other ways of constructing counterfactuals. One is through comparative analysis; ie by comparing two or more countries affected by the same global economic environment and following similar economic policies in general, but different monetary policies. Australia is thus useful (but not conclusive) in at least suggesting that the NZ Reserve Bank's actions did little to reduce inflation.

The other way of constructing counterfactuals is through exhaustive empirical studies. Such studies can suffer from being selective, as I believe some of Milton Friedman's empirical studies are. Still possibly the most exhaustive statistical work on the subject was that done in 1850s' Britain by Thomas Tooke. Tooke's work suggests that prices tend to have a direct but lagging relationship to interest rates, meaning that, historically, falling prices have followed falls in interest rates, and rising prices have followed rises in interest rates.

It must be emphasised that, in a modern context, such an empirical study of the correlation between interest rates and prices must be conducted on a world basis, and not on a national basis.

Let's imagine a world made up of just two countries, say the USA and Euroland. Their currencies have a floating exchange rate. If the US Federal Reserve pushes up US interest rates and Euroland's central bank does not, there is likely to be an increase in world inflation, most of which is experienced in Euroland via a depreciation of the Euro. In effect, high US interest rates create and export cost inflation to Euroland. If Euroland retaliates by raising its interest rates, then world inflation would rise even more, and the USA would get its inflation back (with interest, so to speak) as the Euro returns to its former parity against the US dollar. Inflation might even fall in Euroland as a result of this appreciation, but not back to the level it was before the USA raised its interest rates.

If we looked at the two countries separately, we might find that inflation falls in each after its interest rate hike. But, if we take a GDP-weighted average of both countries' interest rates and inflation rates, we would find world inflation rising after increases in world interest rates. (That relationship might not hold true, however, if world unemployment was very high, meaning that demand deflation would predominate over cost inflation. In such a case, the rate of deflation would be lower than it would be if there was high world unemployment and low world interest rates.)

Paul Jackman believes that the cost impact of interest rates can be dismissed simply by eliminating "credit services" from the CPI. This is disingenuous. Interest rates directly impact on household budgets - the basis of the CPI measure of inflation - and, as he notes, can be removed from the CPI. But my argument is that interest rates affect business costs, which are passed on to consumers through the prices of all products that people consume. It is the indirect cost of high interest rates that contributes to inflation. Similarly, wages represent an indirect cost that influences the CPI. Just because there is no direct "wages" component in the CPI does not mean that wages do not affect the CPI.

I trust that the Reserve Bank will participate in public debate over the causes and effects of inflation, and not simply adopt a didactic tone as if all that can be known about inflation is known to them. While I believe that the Reserve Bank staff have become more pragmatic than they once were, their commitment to monetarism (which is effectively embodied in the Reserve Bank Act) means that they will find it hard to resist pushing interest rates up for any long period of time. Indeed in a speech this afternoon, Governor Brash warned businesses to expect the value of the NZ dollar to rise over the next few years, a sure indication that he expects interest rates to rise.


© 1999   Keith Rankin

Comment from Matthew Smith, University of Sydney (29 Feb 2000)

I read with much interest your article 'Interest Rates and Inflation' (29 Jan 1999) on the Internet.

I have just a few comments about the notion of the money rate of interest as a cost of production which I hope may be useful. In neoclassical economics it is not possible to develop this notion except in disequilibrium when demand inflation or excess supply rule (i.e. when the money rate is below/above the 'natural' rate of interest on capital). Indeed, in neoclassical (or marginalist) economics monetary forces - incl. monetary policy - can exert no lasting influence on the money rate which would be sufficient for it to influence the cost of production. Such a notion can only be developed in classical (or Sraffian) economics in which distribution is open to the long run 'average' money rate governing the normal rate of profit. On such a basis it is possible to show that the money rate (i.e. monetary forces) can exert a positive effect of the normal cost of production and thereby, the price level, in a fiat money system. I refer you to M.Pivetti (1991) 'An Essay on Money and Distribution, NY, St.Martins Press.; also my article M.Smith (1996) 'A Monetary Explanation of Distribution in a Gold Money Economy', in Contributions to Political Economy, vol. 15, 33-61, deals with similar issues in the context of Tooke's day (i.e. nineteenth century Britain). This issue is closely connected to the concept of long-run money neutrality (LRMN) which must hold in neoclassical theory. However, it can be theoretically overcome in classical economic so understood.

Yours sincerely,

Matthew Smith
University of Sydney
Email: matthewlsmith @


Rankin File | 1999 titles