Interest Rates and the Price Level

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.