How high interest rates could drive inflation

The conventional story on interest rates is far from complete

The standard story about interest rates goes like this: you raise interest rates, fewer people borrow money, the “money supply” shrinks, and money retains its value or you stop inflation.

However, this explanation does not fully examine all monetary and credit flows, and the effect on real resources.

MMT Describes the interest income channel

The interest income channel is the money people receive as interest payments. Because governments of all levels carry debt, and that debt is unlikely to be contracted when interest rates rise, the holders of the debt will receive more income in the form of interest payments.

Higher interest payments can pressure firms to charge more money

If firms which are in debt have to make higher interest payments, they may be forced to raise their prices to cover those costs. This can have ripple effects through the economy.

Credit Contraction Can Reduce Real Production

When you contract lines of credit, it is not only the money supply that gets reduced, but also real productive activities. Whenever you reduce real production, that means people have a harder time maintaining a high standard of living. Regardless of the price…