Saturday, March 23, 2019

Short Take: Rates Aren't Indicative of Stance of Monetary Policy

There's a massive misconception that low-interest rates indicate that a central bank is pursuing easy money. In fact, there's a bigger misconception that interest rates, in general, indicate a monetary authority's stance on monetary policy.

Let's say you had a rate of inflation of about 7% and real interest rate of about 3%. This would give you a nominal rate of about 10%. Let's assume you want to reduce the inflation rate because the economy is overheating beyond maximum capacity and the deficit is high. You would, in consequence, reduce the growth rate of the money supply by raising the interest rate (let's say by one percent). In the short term, this increases your nominal rate to about 11% making the real interest rate about 4%.

However, in the long run, inflation goes down. Let's say the inflation rate becomes 4%. The central bank stabilizes the economy so that the real rate is back at 3%. This would give a nominal rate of about 7% which would be lower than your initial nominal rate.

In this example, tight money has led to low rates in the long term. Low-interest rates usually correspond with an increase in the money supply and high-interest rates correspond with a decrease. However, in a real-world setting, low and high-interest rates are not indicative of the current stance of monetary policy. Via the liquidity effect, tight money leads to high rates in the short run. Via the fisher and income effects, tight money leads to low rates in the long run.

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