If I wrote a macro textbook, I would try to avoid any mention of interest rates or inflation. The Fisher equation would use expected NGDP growth. The AS/AD model would use hours worked as the real variable and NGDP as the nominal variable. The transmission mechanism would not involve changes in interest rates, but rather the excess cash balance mechanism. More cash would raise expected future NGDP. This would raise the current price of stocks, commodities and real estate. (As in Islamic economics, there’d be no interest rates.) The higher asset prices would tend to raise current AD. More nominal spending, when combined with sticky wages and prices, would boost output.
But obviously I’m the exception. When rates hit zero and the Fed couldn’t move them anymore, I expected economists to shift over to some other mechanism; the money supply, CPI futures, exchange rates, etc. Instead they started talking about how the Fed could promote a recovery by lowering long term rates. (But if the policy is expected to work, wouldn’t it boost long term rates?) Or they talked about how the Fed could reduce real interest rates by boosting inflation. Some even argued that the Fed would have to boost inflation expectations to 6% in order to get a robust recovery, forgetting that this view directly conflicts with another key assumption of Keynesian macroeconomics—that the SRAS is very flat when unemployment is high.
Some of my commenters argued you couldn’t raise NGDP without first creating inflation expectations, which would lower the real rate of interest. But that’s not necessary at all. If you create higher NGDP growth expectations, then even if expected inflation doesn’t rise at all, the Wicksellian equilibrium real rate will rise and monetary policy will become more stimulative. So the Fed doesn’t need to lower real interest rates in order to stimulate the economy. Conversely, a policy such as interest on reserves might have had a devastating impact on aggregate demand, even if it had no impact on interest rates.
I’m genuinely confused. When we explain why a big crop of apples makes NGDP in apple terms rise sharply, we don’t resort to convoluted explanations involving an interest rate transmission mechanism. Why then, when there’s a big increase in the supply of money, do we think it will only affect nominal GDP in dollar terms via some sort of interest rate transmission mechanism?