Fisher vs Keynes: Does an Interest Rate Hike Cause Inflation to Increase or Decrease?

To answer the question of whether an interest rate hike causes inflation to increase or decrease, I start from the Neo-Classical macroeconomic model. I discuss a challenge in estimating these models due to the discrepancy between the theoretically motivated interest rates and the observed ones. To overcome this challenge, I estimate a liquidity-augmented empirical model of interest rates and inflation using two methods: a time-varying structural vector autoregression and a system of latent variables. I find that an interest rate hike has a short-run negative effect on inflation regardless of its duration. This result contrasts with the Neo-Fisherian hypothesis prediction of a positive short-run response of inflation to a permanent shift in interest rates. At the same time, inflation and the nominal interest rate move in the same direction in the long-run, although not one-for-one. I also find that the short- and long-run interactions of macroeconomic variables including inflation and the interest and growth rates have changed across eras from the 1950s to 2016. Finally, the results reinforce the importance of the liquidity premium on near-money assets in macroeconomic analyses.