Eduardo Loyo on higher interest rates as a cause of inflation

A few quotes from TIGHT MONEY PARADOX ON THE LOOSE: A FISCALIST HYPERINFLATION (PDF) by Eduardo Loyo, June 1999.

From the Abstract:

Higher interest rates cause the outside financial wealth of private agents to grow faster in nominal terms, which in fiscalist models calls for higher inflation. If the monetary authority responds to higher inflation with sufficiently higher nominal interest rates, a vicious circle is formed.

Loyo is clear:

In a fiscalist world, prices are driven not by liquidity, but by the outside wealth of private agents. 

Here, let me give you two whole paragraphs:

Adopting the fiscalist approach to price determination advocated by Eric M. Leeper(1991), Christopher A. Sims (1994) and Michael Woodford (1994, 1995), one can turn that monetarist story right on its head. In a fiscalist world, prices are driven not by liquidity, but by the outside wealth of private agents. Budget deficits, under a fiscal policy regime that causes a breakdown of Ricardian equivalence, add to that wealth stock. Inflation is none other than a symptom of ‘too much nominal wealth chasing too few goods’: it serves to corrode the real value of financial wealth, thus bringing demand back in line with supply. Inflation becomes essentially a fiscal phenomenon.

Just as inflation may have deep fiscal roots even in a monetarist account, so can monetary factors be blamed for inflation in a fiscalist account. That is because monetary policy, changing both the share of government liabilities that bears interest and the interest rate itself, affects the nominal growth of private net worth. But then a ‘tight money paradox’ arises: given the primary budget deficits, tighter money leads to faster growth of outside wealth, and to more rather than less inflation.

His next sentence shows that this analysis does not only apply to hyperinflation:

The reversion comes full circle with regard to explosive inflation, the subject of this paper.

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It's a bit of a twist: Loyo says budget deficits add to private financial wealth, and higher interest rates cause that wealth to grow faster. Both sides of this positive feedback loop support the demand-pull, quantity-of-money story of inflation.

My concern is cost-push: the cost of the money we use to buy the things we ordinarily buy, like food, gasoline, socks, and the occasional puppy. The cost of this money increases with the rate of interest and, more consequentially, with the accumulation of debt. Loyo takes the other side, where debt is an asset rather than a liability.

Both sides, I would argue, may be true: what creates inflationary cost pressure for me can also boost my creditor's wealth, creating the risk of demand-pull inflation if he takes some of his financial income and spends it. But money that's in finance likes to stay in finance. So I don't know.

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One more paragraph from Loyo, and its footnote. On the topic of hyperinflation and modeling it, and the reason for doing so, Loyo writes:

Empirical motivation for such theoretical exercise can be found in the Brazilian experience in the late 1970s and early 1980s. Brazil boasted a thriving market for domestically denominated government debt, an ingredient that enhances the fiscalist departure from conventional results. In 1980, the country underwent a notorious change in monetary policy regime, upon which a fiscalist model would have predicted exactly what came to pass: a switch from stability of inflation rates to persistent inflation acceleration. Conventional explanations for the episode are unsatisfactory, and signs of a tight money paradox have not been lost on a number of observers.²

And footnote 2:

Thomas J. Sargent (1986) hinted at the possibility of a tight money paradox explained by the ‘unpleasant monetarist arithmetic’ of Sargent and Neil Wallace (1981). High interest rates were most frequently mentioned as a cost-push inflationary factor, counting interest on working capital among the costs of production (as in Albert Fishlow, 1971, or in Domingo Felipe Cavallo, 1977). As far as physical inventories are concerned, only movements in the real interest rate should matter; but the nominal interest rate remains the relevant opportunity cost of transactions balances held by firms. Variants of the cost-push argument based on credit rationing, either due to direct government intervention or to market imperfections (as in Alan S. Blinder, 1987) were also very frequent in the structuralist literature (see Samuel A. Morley,1971). Others still echoed Fishlow (1971) with the claim that tight money fueled inflation because it depressed output and increased unit costs of production. Finally, the liquidity services of government debt soon became a prominent theme: if the relevant monetary aggregate is as broad as to include public debt,‘money’ grows faster with higher interest rates. That channel was explored by Carlos Ivan Simonsen Leal and Sérgio Ribeiro da Costa Werlang (1990, 1995), and reviewed in Deepak Lal (1990).

I won't copy the relevant references, but there's a lot of em listed in the PDF. 

Note this sentence right here:

Others still echoed Fishlow (1971) with the claim that tight money fueled inflation because it depressed output and increased unit costs of production. 

Tight money depresses output and increases costs. This is precisely what happens with cost-push inflation. First, the cost pressure creates the need for more money; and second, the refusal to accommodate the need for more money assures that money stays tight.