Are High Interest Rates Effective for Stopping High Inflation? Some Skeptical Notes

Abstract

High interest rates are considered an effective toolfor stopping high inflation. The case for a policy of high interest rates is developed in terms of a conventional IS-LM model. However, among other things, the model ignores some central aspects of modern credit markets. In particular high interest rates may give rise to nonperforming bank loans, thus seriously jeopardizing the effectiveness of the policy. Examples are developed in which it would be optimal to aim for equilibriums of low, rather than high, interest rates. One of these examples hinges on the existence of nonindexed domestic debt. This article looks at the effectiveness and desirability of relatively high interest rates in stabilization programs. High interest rates refer to nominal interest rates that would result in unsustainable, high real interest rates-that is, real rates of interest that would cause a state of generalized bankruptcy if maintained for a few months or a year-if the program's inflation target were to be achieved. The article evolves through a series of examples, beginning with the IS-LM model described in section I. Despite its simplicity (and early vintage), the model is still important in discussions of policy. The conventional IS-LM approach, which gives strong support to a policy of high interest rates, implies that tight money is effective in reducing economic activity and, through the Phillips curve, is also effective in lowering inflation. The larger the interest rate, the sooner price stability will be achieved. Section II questions the relevance of the IS-LM result on the basis of two observations. First, we live in a world in which countries are closely linked from a financial point of view. Therefore high interest rates are likely to signal expectations of high devaluation or inflation. Second, high inflation rates make expected or ex ante real interest rates look much smaller than if the stabilization plan's inflation targets were to be fulfilled. Consequently, banks may continue lending despite high nominal rates. With the passage of timne, however, firms will find themselves in serious financial straits, which eventually may result in a state