Fisher Effect in Econoblogosphere again

Interest in money growth

John Cochrane is developing a model for the Fisher Effect to explain that raising the nominal central bank rate could lead to higher inflation, not lower inflation as many say. Nick Rowe complements the model with a simpler “model”. And Steve Williamson has been an ever-present force for the Fisher Effect. I too have written about this before (link).

I also wrote in June (link) that the extra loosening of monetary policy by the ECB in Europe would be a test of the Fisher effect. Since June, we have seen inflation expectations continue to fall, which supports the Fisher Effect.

Once you realize that firms hedge against extra funding costs by raising prices as I see, and that a rise in the nominal rate is a rise in the money growth rate as Nick Rowe explains, and that coordinated fiscal-monetary policy produces the Fisher Effect as John Cochrane sees… then you see why nominal rates should not fall but rise in order to raise inflation.

Raising the nominal rates by central banks would also increase consumption. John Cochrane and Nick Rowe talk about this.

  • John Cochrane…”In the meantime the higher real interest rates (green) induce a little boom in consumption. So, raising rates not only raises inflation, it gives you a little output boost along the way! “
  • Nick Rowe… “Now remember the relationship between consumption and real interest rates from the standard New Keynesian Euler equation. There is a positive relationship between the level of the real interest rate and the growth rate of consumption.

I presented a video one year ago here on Angry Bear in response to a post from Nick Rowe that talked about how consumption would increase from a rise in nominal rates. The video gave a model of a bifurcated money market between labor and capital where lower interest rates were causing bond prices to rise, inflation to fall and GDP to fall. The bifurcated money market is due to the divergence in money supply between labor and capital income after the crisis. The model supports what Cochrane and Rowe say about a boost in consumption from raising interest rates.

We have had an environment that greatly favors the Fisher Effect to raise inflation and consumption by raising nominal rates… but I think time is running out has run out on this option.