Interest Rates and the Price Level

Paper number: 97/09

Paper date: June 1997

Year: 1997

Paper Category: Discussion Paper

Authors

Campbell Leith
University of Exeter

Paul Warren

Simon Wren-Lewis*
University of Exeter

Abstract

Governments have often combined a monetary policy involving setting nominal interest rates with a fiscal policy that did not seek to target a nominal value of the debt stock. In a model with a traditional backward looking Phillips curve, this fiscal and monetary policy mix may not be stable. If it is stable, then higher interest rates will raise the price level in the long run, even if prices fall in the short term. In the forward looking New Keynesian version of the model, stability requires that governments do not over-adjust fiscal policy in response to changes in the level of readl debt stock. Even if fiscal policy made no attempt to target the real debt stock the model would be stable, because prices can jump on to a stable saddle path which ensures debt stability. In this model a temporary increase in interest raates will always raise inflation and the price level in the short run, and we derive the conditions under which it will raise prices in the long run too.

JEL Classification Nos: E00
Keywords: Price Level Determination, Interest Rates, Fiscal Policy

Corresponding Author: Campbell Leith, Department of Economics, University of Exeter, Amory Building, Rennes Drive, Exeter, EX4 4RJ, Great Britain, tel: (44) 1392 263155, fax: (44) 1392 263242, email: C.B.Leith@exeter.ac.uk

 


* Campbell Leith and Simon Wren-Lewis are at the University of Exeter, and Wren-Lewis is also a fellow of the Centre for Economic Policy Research. Financial support from ESRC grant W116251011 and L116251026 are gratefully acknowledged. We would like to thank David Currie and Chris Williams for help on an earlier version of this paper, and comments from participants at the ESRC Macromodelling Bureau conference at Warwick, UK, but all errors are our own.