09 May 2015

Fed "Tightening" May Bring Inflation

When the Fed raises rates this year, the plan is to do it differently than usual. Rather than reduce the supply of reserves, it will simply raise the interest rate on excess reserves, the effective lower bound to the federal funds rate. There are a few factors playing into this, namely the fact that there are roughly 3 trillion dollars of excess reserves now rather than the previously normal ~50 billion dollars. In order to effect a rate increase, the Fed would have to reduce the supply of reserves to about 1/60th of its current level. Given the impracticality of this, an increase in the IROER (interest rate on excess reserves) seems logical.

An interest rate increase is usually considered synonymous with the attempt of a central bank to decrease inflation. Despite this, given that there will be no change in the money supply, normal monetarist logic would imply that the rate hike would have no effect on inflation whatsoever. $ M_t V_t = P_t Y_t $ with no changes in $ Y $ or $ V $ shows this; $ M $ doesn't change, so $ P $ goes nowhere. Of course, adding a simple ad-hoc money demand equation changes things a little, but not in the expected direction. With $ \log M_t + \eta i_t = \log P_t + \log Y_t $, it becomes clear that raising the interest rate $ i_t $, without decreasing $ M_t $ (assuming $ Y $ is exogenous and constant again) will cause the price level to rise

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