Inflation and Interest Rate Policy

When inflation results from excess demand for goods and services, central banks’ typical response is to increase interest rates. The usual transmission mechanism is: a reduction in money supply (tightening monetary policy) increases interest rates, which is expected to reduce overall spending (both consumption and investment) thus leading in an overall demand reduction and lower inflation. This mechanism does not seem to work in many instances, as many countries (both developed and developing ones) have failed to control inflation despite practicing high interest rate policies. Some could argue that high interest rates harm producers as they feed directly into the costs of production when firms’ operations are mainly funded by loans. The supply side effects of interest rates received attention back in the 1990s, triggered by the observation that contrary to the conventional view, sometimes prices increase after an increase in interest rates, the so-called “price puzzle”. Another factor contributing to inflation, especially for developing countries, is exchange rate movements. Due to the high import content of final goods produced in the country, a depreciation of the domestic currency would increase the cost of production (supply side effects of the exchange rate). Most developing countries are characterized by both high interest rates and weak currencies. Lastly, inflation is highly influenced by inflation expectations, as well. Some argue that high inflation rates have inertial effects. In this paper Hussain et al develop an open economy macro model for a small underdeveloped economy, by incorporating both interest rate and exchange rate supply side effects. They also include inflation, risk premium and exchange rate expectations. The main objective of the paper is to determine the right exchange rate and inflation policies to deal with cost push and demand pull shocks. They solve the model for three types of policies: (i) monetary policy with commitment, (ii) Taylor rule and (iii) inflation targeting. Finally, the researchers assess the relative performance of each of these policies by evaluating the associated social welfare loss/gain to the economy.