r = i - inflation rate
r refers to the real interest rate; and i to the nominal interest rate. Whenever an inflation occurs, the real interest falls. Given that a firm's investment decision is made based on the real interest rate, a falling real interest rate leads firms to invest more. Therefore, lowering nominal interest rate or raising the price level can stimulate the economy in the short run. However, this equation can be rewritten as followed.
i = r + inflation rate
This equation shows that the inflation will eventually raise the nominal interest rate. Therefore, in the long run, the real interest rate may not be affected, and then the inflation cannot stimulate the economy.
Wait, will the inflation raise the nominal interest rate?
Yes. A rising nominal interest rate reflects inflation or loose money. If money is too loose, the nominal interest rate likely rises. Conversely, a falling nominal interest rate reflects deflation or tight money. If money is too tight, the nominal interest rate likely falls. Not my original idea but Milton Friedman's.
http://www.hoover.org/publications/hoover-digest/article/6549
The Federal Reserve has kept the nominal interest rate close to zero for almost 4 years. Some have argued it is an easy money policy showing the low Federal funds rate and huge growth of the monetary base. The truth is entirely opposite. Borrowing from Friedman, the Fed policy was "too little too late."
The U.S. unemployment rate was the worst through the mid 2010. That is the period where the growth rate of money supply measured in money zero maturity drastically fell. One may still argue it is still the positive growth, so that it still represents rising money supply. However, in the meantime, the falling velocity of money not only offset but dragged the growth of money supply below the level required to restore full employment output.
The result seems to be NGDP lower than its potential.
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