Interest Rates and Inflation

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A consensus has emerged among practitioners that the instrument of monetary policy ought to be the short-term interest rate, that policy should be focused on the control of inflation, and that inflation can be reduced by increasing short-term interest rates. At the center of this consensus is a rejection of the quantity theory. Such a rejection is a difficult step to take, given the mass of evidence linking money growth, inflation, and interest rates: increases in average rates of money growth are associated with equal increases in average inflation rates and interest rates. These observations need not rule out a constructive role for the use of short-term interest rates as a monetary instrument. One possibility is that increasing short-term rates in the face of increases in inflation is just an indirect way of reducing money growth: sell bonds and take money out of the system. Another possibility is that, while control of monetary aggregates is the key to low long-run average inflation rates, an interest-rate policy can improve the short-run behavior of interest rates and prices. The shortrun connections among money growth, inflation, and interest rates are very unreliable, so there is much room for improvement. These possibilities are surely worth exploring, but doing so requires new theory. The analysis needed to reconcile interest-rate policies with the evidence on which the quantity theory of money is grounded cannot be found in old textbook diagrams.