To answer the question of whether an interest rate hike causes inflation to increase or decrease, I estimate a liquidity-augmented empirical model of interest rates, inflation, and growth on postwar US data, using three methods: a time-varying structural vector autoregression, a system of latent variables, and a structural vector autoregression with doubtful identifying assumptions. I find that an interest rate hike has a short-run non-positive effect on inflation, regardless of its duration. This result contrasts with the Neo-Fisherian 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.
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Thesis advisor: Herrenbrueck, Lucas
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