Higher interest rates can be expansionary

Here’s Arnold Kling discussing the Great Inflation and its aftermath:

Let me throw a third hypothesis into the mix. There was a fair amount of money illusion in financial markets in the 1970s. That is, people looked at high nominal interest rates and thought that this would slow down inflation. In fact, interest rates were not high enough. Relative to financial markets, the Fed was following rather than leading. It was reflecting the views of Wall Street. Finally, in the early 1980s, the “bond market vigilantes” took over, and we had high real interest rates, high unemployment, and a slowdown in inflation. Just to be clear, I am giving the credit for high interest rates to the bond market vigilantes, not to Paul Volcker.

This is a good example of the problems associated with “reasoning from price change.” Kling is implicitly associating higher interest rates with contractionary policy. That might be true if the higher interest rates are caused by a contraction in the money supply (giving credit to Paul Volcker.) However in this case Kling is holding the money supply fixed and assuming the higher interest rates are caused by higher inflation expectations. In that case the higher interest rates will lead to higher nominal GDP growth and inflation, because higher nominal rates tend to increase velocity.

Note that this is not some sort of weird “market monetarist” result. Higher inflation expectations are also expansionary (or at least non-contractionary) in the new Keynesian model.

BTW, NGDP growth reached an annual rate of 19% in late 1980 and early 1981.  Volcker is to blame for that surge.



9 Responses to “Higher interest rates can be expansionary”

  1. Gravatar of Tommy Dorsett Tommy Dorsett
    11. November 2013 at 11:59

    Yup. The level of rates is highly positively correalted to velocity (the inverse of the demand for money balances). So, if M is held constant, higher rates should mean higher/faster NGDP:


  2. Gravatar of Tommy Dorsett Tommy Dorsett
    11. November 2013 at 12:30

    Kling also seems to assume — falsely — that the high real rates of the early 1980s had nothing to do with the Fed. Yet Volcker pushed the funds rate 10 percentage points above core inflation in 1981, just before a big slowdown in NGDP and a very sharp 18-month recession:


    The idea that the so called bond vigilantes can raise or lower the trend rate of NGDP/inflation without the Fed bringing the target/administered rate into line with the Wicksellian equilibrium is goofy but popular on Wall Street.

    What would have occurred between 1981-1985 had the Fed kept real short rates at zero (when the equilibrium was high and rising?). Surely, we cannot assume a sell-off in the long bond would have cancelled any inflation upsurge. Quite the opposite, I’m afraid.

  3. Gravatar of Geoff Geoff
    11. November 2013 at 16:46

    “BTW, NGDP growth reached an annual rate of 19% in late 1980 and early 1981. Volcker is to blame for that surge.”

    Never reason from an NGDP change.

    Volcker was not very active in 1980-1981:


    This is what Volcker was directly in control of.

    He wasn’t directly in control of NGDP. NGDP is a function of both Fed activity, government activity, and market activity. If the market wanted, it could hoard every single nickel the Fed created for however long the market wanted, and the Fed would be virtually powerless to reverse it. NGDP would collapse. The only thing the Fed could do here would be to convince the Treasury to spend like gangbusters, or the Fed could start buying capital and consumer goods directly, on a daily basis, while the receivers of said money continue to hoard. As long as the Fed is constrained to increasing bank reserves, the market has ultimate control.

    You can print me $100 billion in new money every day if you wanted, but if I don’t choose to spend any of it, you won’t be able to get your way. I have the final choice if you depend on my spending.

    Volcker dramatically inflated reserves starting in 1982, and then again in 1985.

  4. Gravatar of benjamin cole benjamin cole
    11. November 2013 at 18:03

    Excellent blogging. As Sumner has illuminated, Volcker—a towering figure in the inflation-fighting hagiographies—was a reckless moneyprinter compared to the “dovish” Bernanke…the Fed’s internal culture has now diefied and ossified around inflation-fighting…

  5. Gravatar of lxdr1f7 lxdr1f7
    11. November 2013 at 21:24

    How can the fed increase inflation expectations?

  6. Gravatar of lxdr1f7 lxdr1f7
    11. November 2013 at 22:57

    Isn’t a permanent increase in base determined endogenously? The fed can increase base (primarily through excess reserves) but unless lending and economic activity pick up it wont be permanent.

  7. Gravatar of ssumner ssumner
    12. November 2013 at 06:52

    Tommy. Good point.

    lxdr, No, the Fed can increase the base as much as it likes. The public has no say in the matter. The public controls the real size of the base, but the Fed controls the nominal size of the base.

  8. Gravatar of lxdr1f7 lxdr1f7
    12. November 2013 at 07:44

    “The public controls the real size of the base”

    Does that mean the public control inflation and not the fed?

  9. Gravatar of ssumner ssumner
    14. November 2013 at 20:10

    Lxdr, No, the Fed controls inflation, as they can offset changes in the real demand for money with more or less supply.

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