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April 28, 2014

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Hangingnoodles

"Mechanism" connotes ideas that may be too deterministic for something as complex as an economy. A distinction between ideas & tools "honed in the 'olicausal sciences' (oli = few) handle" vs new ideas/tools for handling greater polycausal complexities may be useful. See Isaiah Berlin on how “because” is used differently in science and history:
http://t.co/4CE301ekLg

Peter M

A demand-side mechanism through which interest rates and inflation could be correlated is an Income Effect. Most simply, increases in real interest rates increase the return to savings, which could potentially stimulate demand in the present period because less savings are needed to achieve any specified level of future wealth (same mechanism as a backwards bending labor supply curve).

From a consumption perspective, therefore, if this income effect is greater than its offsetting substitution effect, we could see increasing real interest rates increase consumption. If this increase in consumption is greater than decreases in investment caused by real interest rate increases, we could in fact see demand increase, and thus inflation too.

chris

I certainly wasn't intending "mechanism" to be so deterministic. Quite the opposite. The idea I'm driving at is that there are many possible mechanisms which work in opposite directions. Which ones are switched on or off (or are strong or weak) varies from time to time and place to place, and maybe can only be discerned after the event.
That's not very deterministic, is it?

Luis Enrique

I could buy the idea that higher rates cause some firms to raise prices, but that sounds like a one off story. Why would higher interest rates cause recurring price increases (inflation)?

rogerh

Do higher interest rates depress demand? Maybe this depends on whom the interest rates fall and whether people have any choice about spending and perhaps the age and wealth of the spenders. Up to a point petrol and potatoes and the mortgage are a must-have - no choice. But new cars and new Iphones say have their interest rate kept down or concealed by the vendors and so don't affect demand that much - provided you are not really up against it. Then there are the retired, they might as well spend money as leave it rotting in the bank. The wealthy and the foreigners don't care anyway. So interest rates can go up a fair bit (from a low base) before they bite hard enough to clamp down a low level of inflation. Sadly unemployment can go up and down a fair bit without affecting this picture very much. So I reckon it all depends where on the interest rate/demand/demographic/anydamnthing map you start from and the slope of the curve(s) at those various points. The 1970s and 80s were a very different country.

chris

@ Luis - if inflation expectations are adaptive we could get persistent inflation. (The fact that rate rises tend to be serially correlated, and staggered price setting, would also give us a burst of inflation)

Luis Enrique

Hi Chris,

so what would be a one-off price level change is transformed into recurring inflation?

that sounds plausible, and as you indicated (adaptive expectations) if this sort of thing happens in reality then rational expectations models are the wrong tools for trying to understand inflation.

chris

@ Luis - yes, that's what I'm getting at.
One complication here, though, is that expectations formation isn't necessarily stable. In normal times, folk seem to use adaptive expectations ("inflation will be what it's been"), but in dramatic times they become more forward-looking, as I suggested here:
http://stumblingandmumbling.typepad.com/stumbling_and_mumbling/2013/11/on-rational-expectations.html

Luis Enrique

on the other hand we recently had a burst of inflation, probably from cost push / terms of trade reasons, and that didn't turn into recurring inflation.

one might even have thought, given the number of people who seem to believe that QE will be inflationary, that people would be primed to interpret any one-off inflationary shock as the harbinger of coming inflation and if self-fulfilling adaptive expectations mechanisms are strong, hard to explain experience of recent years?

Metatone

I think rogerh adds something important here, along with Luis Enrique's last point. Interest rate _reactions_ to inflationary circumstances are effective or not, depending on what those circumstances are.

Very simply:

An ongoing cost push in a vital, foreign sourced raw material (e.g. oil or gas for many countries) will push up inflation and changing interest rates (basic mechanism, inducing a recession) may not have much impact on price levels affected by said vital material..

On the other hand if there truly is some "wage-price spiral" in action, then inducing a recession can cause wage increases to stop.

Now you can go into intermediate mechanisms about borrowing (short and medium term) & savings (medium term) but the story of effective interventions (e.g. Volcker, Thatcher) almost always involves a recession and I think it's important to take that seriously when looking at mechanisms.

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