...will an increase in the rate of interest paid for holding money be deflationary (because it increases the demand for money), or inflationary (because it increases the growth rate in the supply of money)?
This question crops up from time to time, in comments here and on other blogs, so I thought I would lay out a simple answer. Mostly as a "teaching" post, but also because it raises an interesting question about interest on reserves and central banks' communications strategy.
The answer is: an increase in the rate of interest paid for holding money will increase the equilibrium inflation rate; but it will not cause an additional one-time jump up or down in the equilibrium price level. (Yep, you gotta keep your head clear on the distinction between levels and rates of change over time.)