"On Modeling the Effects of Inflation Shocks"
2002, Contributions to Macroeconomics, Vol. 2: Iss. 1, Article 3.
The results in this paper suggest, however, that an inflation shock with the
nominal interest rate held constant has a negative effect on real
output. There are three reasons.
First, the data support the use of nominal
rather than real interest rates in aggregate expenditure equations.
Second, the evidence suggests that the
percentage increase in nominal household wealth
from a positive inflation shock
is less than the percentage increase in the price level,
which is contractionary because of the fall in real wealth.
Third, there is evidence that wages lag prices, and so a positive
inflation shock results in
an initial fall in real wage rates and thus real labor income, which is
If these three features are true, they
imply that a positive inflation shock has a negative
effect on aggregate demand even if the nominal interest rate is held
constant. Not only does the Fed not have to increase the nominal interest
rate more than the increase in inflation for there to be a contraction,
not have to increase the nominal rate at all!