Inflation and Real Interest

Inflation and Real Interest

Mundell argued that inflation could lower the real interest rate permanently as wealth holders rebalance portfolios away from money and reduce consumption. This point was independently made by Tobin (1965) and has come to be known as the “Mundell-Tobin” effect.

This well-known non-neutrality illustrates Mundell’s re-orientation of the profession away from a simple focus on flow equilibrium and towards explicit consideration of stocks and the dynamics that issue from wealth changes.

Introduction to the 1963 study:

The theory of interest under inflation needs further investigation. Irving Fisher’s analysis, which concluded that the money rate of interest rises by the anticipated rate of inflation or falls by the anticipated rate of deflation, was subjected to attack by Keynes: “The mistake lies in supposing that it is the rate of interest on which prospective changes in the value of money will directly react, instead of the marginal efficiency of a given stock of capital.” Fisher himself seems to have had misgivings about the empirical reliability of his explanation and presented evidence suggesting that the adjustment of money interest was only partial, concluding:

When the cost of living is not stable, the rate of interest takes the appreciation and depreciation into account to some extent, but only slightly, and, in general, indirectly. That is, when prices are rising, the rate of interest tends to be high but not so high as it should be to compensate for the rise; and when prices are falling, the rate of interest tends to be low, but not so low as it should be to compensate for the fall.

Later he showed that the real rate of interest was much more variable than the money rate and conjectured that: “Men are unable or unwilling to adjust at all accurately and promptly the money interest rates to changed price levels…. The erratic behavior of real interest is evidently a trick played on the money market by the “money illusion” when contracts are made in unstable money.” Thus Fisher found verification for a theory of partial adjustment of money interest to inflation and deflation but none for his own theory of complete adjustment under foresight. And to attribute the discrepancy between theory and reality solely to lack of foresight is to raise doubts about the nature of the evidence that would be required to reject the theory.

The theory presented in this paper is more consistent with Fisher’s empirical observations than his own theory, for it shows that anticipated inflation or deflation is likely to raise (lower) the money rate of interest by less than the rate of inflation (deflation) itself. It is also consistent with Keynes’s theoretical criticism of Fisher, yet paradoxically retains the concept of an equilibrium interest rate uninfluenced by unanticipated once-for-all changes in the quantity of money.