Misperceptions about Monetary Policy and a Self-Confirming Inflation Trap: Can Opposition to Interest Rate Hikes Prolong Inflation?

Abstract

This paper develops a simple dynamic model to examine how the public misperception that “higher interest rates increase inflation” may constrain monetary policy and, as a result, actually prolong inflation. Under the standard monetary policy transmission mechanism, an increase in the policy interest rate reduces future inflation. However, when a central bank raises interest rates in response to high inflation, the public observes a positive association between high interest rates and high inflation. If individuals confuse the central bank’s policy response with the causal effect of monetary policy, they may form the mistaken belief that interest rate hikes increase inflation. This paper considers an environment in which such a misperception strengthens public opposition to rate hikes and thereby weakens the effective degree of monetary tightening. The analysis shows that when the misperception exceeds a critical threshold, inflation no longer declines and may instead persist or increase. Moreover, if persistent inflation reinforces the initial misperception, the economy may fall into a self-confirming monetary policy trap.