A sharp colleague recently pushed me to write down a really simple model that
can clarify the intuition of how raising interest rates might raise, rather than lower, inflation.
Here is an answer.

(This follows the

last post on the question, which links to a paper. Warning: this post uses mathjax and has graphs. If you don't see them, come back to

the original. I have to hit
shift-reload twice to see math in Safari. )

I'll use the standard intertemporal-substitution relation, that higher real interest rates induce
you to postpone consumption,
\[
c_t = E_t c_{t+1} - \sigma(i_t - E_t \pi_{t+1})
\]
I'll pair it here with the simplest possible Phillips curve, that inflation is higher when output is higher.
\[
\pi_t = \kappa c_t
\]
I'll also assume that people know about the interest rate rise ahead of time,
so \(\pi_{t+1}=E_t\pi_{t+1}\).

Now substitute \(\pi_t\) for \(c_t\),
\[ \pi_t = \pi_{t+1} - \sigma \kappa(i_t - \pi_{t+1})\]
So the solution is
\[
E_t \pi_{t+1} = \frac{1}{1+\sigma\kappa} \pi_t + \frac{\sigma \kappa}{1+\sigma\kappa}i_t
\]

Inflation is stable. You can solve this backwards to
\[
\pi_{t} = \frac{\sigma \kappa}{1+\sigma\kappa} \sum_{j=0}^\infty \left( \frac{1}{1+\sigma\kappa}\right)^j i_{t-j}
\]

Here is a plot of what happens when the Fed raises nominal interest rates, using \(\sigma=1, \kappa=1\):

When interest rates rise, inflation rises steadily.

Now, intuition. (In economics intuition describes equations. If you have
intuition but can't quite come up with the equations, you have a hunch not a result.) During the time of high real interest rates -- when the nominal rate has risen, but inflation has not yet caught up -- consumption must grow faster.

People consume less ahead of the time of high real interest rates, so they have more savings, and earn more interest on those savings. Afterwards, they can consume more. Since more consumption pushes up prices, giving more inflation, inflation must also rise during the period of high consumption growth.

One way to look at this is that consumption and inflation was depressed before the rise, because people knew the rise was going to happen. In that sense, higher interest rates do lower consumption,
but rational expectations reverses the arrow of time: higher future interest rates lower
consumption and inflation today.

(The case of a surprise rise in interest rates is a bit more subtle.
It's possible in that case that \(\pi_t\) and \(c_t\) jump down unexpectedly at time \(t\) when \(i_t\) jumps up.
Analyzing that case, like all the other complications, takes a paper not a blog post. The
point here was to show a simple model that illustrates the possibility of a neo-Fisherian
result, not to argue that the result is general. My skeptical colleauge wanted to
see how it's even possible.)

I really like that the Phillips curve here is so completely old fashioned. This is Phillips'
Phillips curve, with a permanent inflation-output tradeoff. That fact shows
squarely where the neo-Fisherian result comes from. The forward-looking intertemporal-substitution IS equation is the central ingredient.

Model 2:

You might object that with this static Phillips curve, there is a permanent
inflation-output tradeoff. Maybe we're getting the permanent rise in inflation from the permanent
rise in output? No, but let's see it. Here's the same model with an accelerationist Phillips curve, with slowly
adaptive expectations. Change the Phillips curve to
\[
c_{t} = \kappa(\pi_{t}-\pi_{t-1}^{e})
\]
\[
\pi_{t}^{e} = \lambda\pi_{t-1}^{e}+(1-\lambda)\pi_{t}
\]
or, equivalently,
\[
\pi_{t}^{e}=(1-\lambda)\sum_{j=0}^{\infty}\lambda^{j}\pi_{t-j}.
\]

Substituting out consumption again,
\[
(\pi_{t}-\pi_{t-1}^{e})=(\pi_{t+1}-\pi_{t}^{e})-\sigma\kappa(i_{t}-\pi_{t+1})
\]
\[
(1+\sigma\kappa)\pi_{t+1}=\pi_{t}+\pi_{t}^{e}-\pi_{t-1}^{e}+\sigma\kappa i_{t}
\]
\[
\pi_{t+1}=\frac{1}{1+\sigma\kappa}\left( \pi_{t}+\pi_{t}^{e}-\pi_{t-1}
^{e}\right) +\frac{\sigma\kappa}{1+\sigma\kappa}i_{t}.
\]
Explicitly,
\[
(1+\sigma\kappa)\pi_{t+1}=\pi_{t}+\gamma(1-\lambda)\left[ \sum_{j=0}^{\infty
}\lambda^{j}\Delta\pi_{t-j}\right] +\sigma\kappa i_{t}
\]

Simulating this model, with \(\lambda=0.9\).

As you can see, we still have a completely positive response.
Inflation ends up moving one for one with the rate
change. Consumption booms and then slowly reverts to zero. The words are really about
the same.

The positive consumption response does not survive with more realistic or better grounded Phillips curves. With the standard forward looking new Keynesian Phillips curve inflation looks about the same, but output goes down throughout the episode: you get stagflation.

The absolutely simplest model is, of course, just \[i_t = r + E_t \pi_{t+1}\]. Then if the Fed raises

the nominal interest rate, inflation must follow. But my challenge was to spell out the market forces

that push inflation up. I'm less able to tell the corresponding story in very simple terms.