Interest Rates and Inflation

Using a model of segmented markets, it is shown that a policy of increasing short-term interest rates to reduce inflation can be rationalized with essentially quantity-theoretic models of monetary equilibrium. In the model used to generate all specific examples, production is a given constant, velocity is an exogenous random shock, and the equation of exchange determines the equilibrium price level, given the money supply. In this theory of inflation, consistent with much of the evidence, interest rates play no role whatsoever. To rationalize the use of any interest rate rules, it would be necessary to use an objective function that assigns weight to some other objective besides the attainment of an inflation target.