TheFederal Reserve Bank raised its interest rates because they believedthat this was to push inflation to its targeted point. However, thenew school of thought is against this reasoning and argues theopposite of it (Kradin, 2015). Most of the macroeconomic models arguethat reduced interest rates stimulate borrowing and spending. Thiswill later lead to increased price of goods because of the increaseddemand.
Thenew theory, “neo-Fisherism theory” developed by the Americaneconomist Fisher, provided a basic foundation in studying inflationand monetary policy. He gave his insights of the reason the prices ofgoods changes in the economy. The Fisher effect suggests that thereis a close relationship between inflation and the interest rates. Ina booming economy, it makes sense to raise the interest rates whilein a slow economy the only option is to lower the interest rates.Reduced inflation can be achieved through low interests, but theeffect of declined inflation will be felt during recession periods.
Asargued by Mr. Bullard, low-interest rates in the short-run boosts theoutput. However, in the long run, individual expectations may takecontrol forcing inflation to reduce. Citing the case of G-7 in theyear 2009 where interest rates drastically fall to zero, it wasobserved that inflation increased to 3% in the year 2012 before itagain reduced to zero (Gwartney, 2009). Therefore, through thesestudies by prominent economists, it can be concluded that theinterest rates are inversely proportional to one another.
Thoughthe neo-Fisherman theory has made a positive contribution in studyingthe economy of a country, it’s accompanied by shortcomings thatinhibit its application in the economy. For instance, the observationof Mr. Bullard concerning inflation is heavily manifested in studyingthe price of oil. When oil was not considered, inflation wasrelatively stable varying at around 2% across the world as well as inthe USA (Ip, 2013). In the recent times, this figure is seen reducethan it was the case previously. Some bloggers are of the idea that,it may be worth nothing to argue that the recent low inflation ratesare caused by the low-interest rates. But, it makes sense to arguethat the low-interest rates are a result of low inflation, and theinflation has remained low because it should be much lower than itis. When studying the responsiveness of demand and interest rates, ithas been argued that the response of demand to interest rates is veryslow (Brigham, & Ehrhardt, 2010). In this case, the state of theequilibrium rate can be negative. The Fed will be unable to shift thenominal rates to any point below zero meaning the monetary policy isvery tight.
Neo-Fisherismsuggests that the perceived interest rates that the public expect aredriven by the fixed real rate. Most people’s expectation of theinterest rate is based on past experiences. The savings andinvestment of individuals will be affected by the inflation rates.For this neo-Fisherman theory to work, private sectors should spendless and expect high prices in response to the high-interest rates.But firms and individuals do not behave this way often (Kim, 2015).
Toconclude, neo-Fisherism is right only that it’s indeed hard topredict inflation because it is as well affected by other factorsother than the state of the economy and the monetary policies (Ip,2013).
Brigham,E. & Ehrhardt, M. (2010). FinancialManagement: Theory & Practice.Cengage Learning.
Gwartney,J. D. (2009). Economics:Private and Public Choice.Australia: South-Western Cengage Learning.
Ip,G. (2013). TheLittle Book of Economics: How the Economy Works in the Real World.Hoboken, N.J: Wiley.
Kim,M. (2015). Neo-FisheriteTheory of Recession.Availableat SSRN 2685014.
Kradin,R. (2015). GregIp: Could Higher Interest Rates Lead to Inflation? ExplainingNeo-Fisherism.Retrieved fromhttp://blogs.wsj.com/economics/2015/12/08/greg-ip-could-higher-interest-rates-lead-to-higher-inflation-explaining-neo-fisherism/,12thDecember 2015.