Nonlinear impact of interest rates on price level (smooth transition autoregressive approach)

Abstract

Economic and monetary policy-making shall benefit from the nominal interest rates and inflation causal relationship for macroeconomic issues. In this paper, by expanding Fisher’s Quantity Theory of Money, we investigate this relationship using the “Smooth Transition Autoregressive” approach for Iran's economy.The results show that when the interest rate rises (particularly when it exceeds the threshold), its positive impact on inflation will increase. Moreover, the effect of a low-interest rate increase does not have a severe effect on price change. It is concluded that interest rate is not a good policy instrument for high inflation dampening, and those policies that diminish money circulation velocity might be more effective for general price level control. Macro-economically, the results show that in the long run, interest rate yield that is paid to the factors of production is practically eliminated by reducing the purchasing power of money due to the price increase in the economy.This might be understood as one of the pearls of wisdom that Almighty God has cited in the Holy Qur'an about the prohibition of usury: "God effaces usury"5 means that Almighty God eliminates the effects of the usury yield increment in the economy.Interest rate, Price, Smooth Transfer Autoregressive Model, Quantity Theory of Money, Irving Fisher.