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I am reading a book about the Mundell-Fleming Model and I have encountered a part which says:

The Fed raised U.S. interest rates several times during 1994 to prevent U.S. inflation.

Isn't it the other way round? I thought that rising interest rates causes the investment to decrease and so the money demand to decrease. When money demand decreases, price level increases. Am I wrong?

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The increase in interest rates make borrowing more expensive and therefore businesses and people will borrow less. Therefore, investment and consumption decrease. Through the multiplier effects, this will cause a reduction in real GDP. This will also increase the unemployment rate. Therefore, people who sell these goods and services will reduce their prices. As a result, the overall price level will fall and the inflation rate is reduced. I understand that explanation where the money demand decreases cause a probable eventual reduction in the interest rates. However, this assume that the money supply is fixed. Now, you must understand how the Fed controls the interest rates. It controls the interest rates by controlling the money supply. It reduces the money supply by selling bonds into the economy. Therefore, the money supply shift to the left and initially, the interest rates soar. The demand and supply analysis:

  1. First we must define some basics: We are going to use the supply and demand graph with the interest rates as the y axis and the money in x axis. Now since we know that there is a fixed amount of money in the economy and the Fed is controlling it, we know that the supply of money is strictly vertical and the demand for money is downward-sloping (with a certain elasticity)

  2. The mechanism of the money diagram: In a fixed money supply, if there is an increase in demand of money, the demand curve will shift to the right. Now if there is a a positive inflation rate, there is an increase in demand of money with every inflation rate and therefore the demand curve will shift to the right.

  3. The fed aims to reduce inflation by increasing interest rates. They do this by reducing the amount of money in the economy and thus shifting the supply curve of money to the left. You are right when the total quantity of money in the equilibrium point will be reduced. However, I think that you are confused why the interest rates will not go down. This is because the Fed aims to reduce positive interest rates and not cause a negative inflation rate. In argument (2) I have explained that with a positive inflation rate, the money demand curve will always be shifting to the right. Therefore, the Fed only wants to reduce the speed of that shift.

Now you wonder why the Fed wants to reduce the inflation rate. This is because it is always desirable to have a steady price level. A high inflation rate causes some cost to the economy that it does not want. You need to google or search in the wikipedia for the negative effects of high inflation rates.

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The Fed raised U.S. interest rates several times during 1994 to prevent U.S. inflation.

I'm not an economist. I'm simply interested in the aspect of economics which doesn't require a degree to understand and appreciate. It might well be better categorized as common sense, if only it were a little more commonly sensed.

Inflation is generally thought of as rising prices. But this diverts attention from who is doing the raising... or who is forcing others to raise prices?

'Price inflation' should be distinguished from 'inflation'. Price inflation means putting prices up. Inflation, on the other hand means causing others to put prices up. How is this done?

Well, governments increase the money supply, through their central banking agents. This i.e. the money supply,is what is really being inflated, which causes a secondary - price - inflation.

When people put up prices, part of that is genuinely finding a suitable price to move goods and services. And the other part of it - the part central planners generally don't like to talk about - is goods and service providers trying to limit the effect of money-supply inflation i.e. the erosion of their currency's purchasing power.

Whenever the Fed raises or lowers rates it is engaging in price-fixing. But to answer your question, when the Fed raises rates, it is making borrowing more expensive and lending more rewarding. So the effect is to encourage investment in capital infrastructure.

The only problem is that the signals, that this change (in the amount of increased investment in any particular industry) emanated from, did not originate from consumers expressing their needs and wants - with the attendant risks which should be theirs to bear or mitigate. No, instead the signal came from a third, intervening, party, who bears virtually none of the risk if the change turns out to have negative consequences for those who's expressed preferences in the market were overridden by the third party i.e. the government agent (the Fed), setting interest rates.

Interest rates are merely the price of money i.e. what 'borrowing it' is selling for on the market. As such, interest rates are like any other price... they should be set by consumers who bear the risk, where they do not mitigate against the risk. They should not be fixed any more than cellphone prices or the prices of bananas, or t-shirts.

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Raising interest rates increases inflation.

Economists rarely study Business eve less Cost Accounting.

Companies sell with 30 to 60 terms of trade, and when interest increases from zero, to 10%, a didactic example, their Trade Prices increase 10 or 22%.

Unfortunaely, Economics do not incude these prices in their inflation indexes when they are paid, 60 days in the future, but when the transaction occurs.

So they are including tomorrow's inflation, 60 days into to future, in today's inflation rate. That will create a vicious spiral of inflationary pressures.

I have explained this to every single government Economists in Brazil, and I get the sense that cannot admit that they have been the main cause of inflation over the last 100 years.

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    $\begingroup$ It's a bit more complex than that. Companies can put their prices up to whatever they wish, but there has to be money available in the hands of their customers otherwise they won't make any sales. With a bounded money supply, the prices stabilise at an equilibrium level - so you may want to look into why the Brazilian money supply isn't bounded. $\endgroup$ – Lumi Jun 15 '15 at 13:53
  • $\begingroup$ I won't claim to be an expert in this exact area, but you may want to consider that it is a possibility that if every single government economist in Brazil disagrees with you then it is you, not them, that is mistaken. $\endgroup$ – cc7768 Jun 15 '15 at 15:31

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