THE FINANCIAL AND TAX EFFECTS OF MONETARY POLICY ON INTEREST RATES

Standard analysis of monetary policy effects on interest rates in terms of liquidity, income, and expectations effects is incomplete. After a change in monetary policy, substitution among securities will increase as time elapses and so reduce or eliminate financial effects caused by short-run financial market segmentation. Also, the standard expectations effect omits the transfer of income tax liability on that part of the interest payment representing a return of real capital. So a 1 percentage point increase in the expected inflation rate should increase the nominal interest rate by 1/(1 —τ) percentage points, τ being the marginal tax rate.