Inflation and the Fed

Ask an Economist
Question: 

I understand that inflation occurs when demand for commodities far exceeds supply (like now) and that the Fed typically raises interest rates to lessen overall demand and reduce/control inflation. This approach seems focused on addressing demand, but does it also affect supply? Businesses want to expand their capacity to meet higher demand and typically need capital to do that. Does the policy of increasing rates ultimately limit businesses ability to expand further hindering their ability to meet demand? Wouldn't be better if we lent more aggressively to businesses so that they could increase capacity rather than reducing demand?

Answer: 

Standard theory describes channels through which raising rates affects both demand and supply.  Higher rates raise the opportunity cost of spending and thus tend to dampen both business investment and household consumption.  All else equal, when households spend less, they save more, and this additional savings increases the aggregate capital stock.  Furthermore, to the extent leisure is a normal good and is substitutable over time, higher rates may increase current aggregate labor supply.  So, although higher rates are thought to primarily impact the economy by slowing aggregate demand, they may also boost aggregate supply by increasing the inputs to production (i.e., capital and labor).  Of course, the result of weaker demand and greater supply is downward pressure on prices.

That said, economists have proposed alternative channels through which higher interest rates can increase inflation.  The so-called “cost-channel” of monetary policy – see, e.g., Barth and Ramey (NBER Macro Annual, 2001) – posits that an increase in nominal interest rates raises production costs, say because it increases firms’ cost of financing their working capital, and thus leads to an increase in prices and a decline in output.  And the fiscal theory of the price level – see, e.g., Cochrane (Journal of Economic Perspectives, forthcoming) – emphasizes that monetary and fiscal policy interact.  An increase in interest rates raises the interest costs of government debt, and this will lead to more inflation if the government is not expected to alter its future deficits/surpluses (but could alternatively bring about disinflation if accompanied by an expected fiscal tightening and increased surpluses).

Whether raising rates is the appropriate policy to lower inflation requires assessing these various channels and considering the conditions that led to the outbreak of inflation in the first place.  Under standard theory, if inflation was caused by a “supply shock”, which would tend to boost prices but lower output, raising rates may not be appropriate.  But, if prices and output are both high, thus suggesting a “demand shock”, raising rates is more likely to be the appropriate policy response.

Answered by:
Last updated on April 4, 2022