A Note on the Real Effects of Interest Rate Policy and Its Impact on Inflation

ABSTRACT

The interest rate is viewed in this note as a monetary phenomenon, subject to a wide range of policy objectives and constraints, which contributes to determine activity levels principally through its effects on income distribution. The impact of interest-rate policy on inflation is also analysed, both in the light of the fact that the rate of interest constitutes a component of normal production costs and of the repercussions of its changes on employment. The note finally discusses the implications of the arguments put forward for the status of the central bank and capital control.

KEYWORDS:

• Interest rates
• monetary policy
• inflation

Acknowledgements

I wish to thank an anonymous referee of this journal for useful comments and suggestions.

Disclosure Statement

No potential conflict of interest was reported by the author(s).

Notes

1 The idea that the quantity of money is endogenous can be found also in works that aimed at integrating money and banking into real business cycle theory (see e.g. King and Plosser 1984) as well as in works belonging to the inflation targeting framework (cf. on this Pivetti 2010).

2 Consider, for example, a country that adheres to a fixed exchange-rate regime cum financial liberalisation and is compelled by it to stick to a comparatively dear-money policy. Concern would then mount over time as to the impact of dear money on domestic costs and prices (more on this below, in the text). This, in turn, would put pressure on wage earners to restrain their wage demands so that cheap labour might compensate for dear money. At the same time, the high cost of servicing the government debt would put pressure on budgetary policy, with the formation of primary surpluses tending to be pursued to service the debt and check its rise. Now, it is highly unlikely that such a sequence of events – from the abolition of restrictions on capital movements to the high interest policy and the budgetary stringencies – could come about and be allowed to persist unless wage earners of the country concerned happened to find themselves in an increasingly weak position.

3 It is widely acknowledged in the literature that by directly controlling short-term rates monetary authorities are generally capable of also governing the course of long-term rates. The connection between short and long-term rates may be variously accounted for conceptually: arbitrage and competition in the capital markets; the influence that the present course of short-term rates exerts on the market opinion about the future course of long-term rates; or the ‘expectation theory of the term structure’ according to which longer-term rates move with an average of expected future short-term rates. But independently of how it is accounted for, the connection between the policy determined short-term rates and long-term interest rates is supported by the mere empirical evidence that, through time, short and long-term rates behave consistently with each other (cf. Deleidi and Levrero 2021, for a recent empirical verification of this connection for the US case).

4 It is pertinent here to remember that over the years leading to the financial crisis of 2007–2008 a cheap money policy was imposed on the authorities of a few major capitalist countries also by a growth strategy crucially based on the expansion of household debt – actually, on a process of substitution of loans for wages (see on this Barba and Pivetti 2009).

5 This is actually the reason why Marx regarded the normal rate of profit as the fundamental regulator of capital accumulation – the magnitude indicated in his writings as ‘the stimulating principle of capitalist production, the fundamental premise and driving force of accumulation’ (1894, p. 259).

6 In the last chapter of the General Theory Keynes acutely observes that ‘it is not necessary that the game should be played for such high stakes [such a high prospective level of profit] as at present. Much lower stakes will serve the purpose equally well, as soon as the players are accustomed to them’ (Keynes 1936, p. 374).

7 Robust evidence has indeed been given of the fact that interest rates are regarded by firms as a cost, with the corollary that they look to establish a price rise in response to increased interest rates (see e. g. Scovell 1924, p. 21, where it is argued that the inclusion of interest in cost is ‘not only theoretically proper but practically necessary’; see also Barth and Ramey 2001, pp. 17–18; and Gaiotti and Secchi 2004).

8 What should actually be rebuilt to contain wage demands in situations of persistent high employment and strong wage earners' bargaining powers is the generous social-democratic welfare order carefully put together in a large part of Europe over the first post-WWII 30-year period, an order made viable over time also by markedly progressive taxation systems.

9 Keynes could thus declare in the House of Lords that what in the pre-war system ‘used to be a heresy’, in the field of international capital movements, ‘it is now endorsed as orthodox’ (Keynes 1944, p. 17). It is worth noting that the IMF has in recent years somewhat revalued its old post-war position in favour of capital controls (see IMF 2012, and also Adrian et al. 2022).