Keywords: Monetary policy; equilibrium determinacy; Taylor rule; sunspot fluctuations
Abstract: The data across time and countries suggest the level and variance of inflation are highly correlated.
This paper examines the effect of trend inflation on the ability of the monetary authority to ensure a
determinate equilibrium and macroeconomic stability in a sticky-price model. Trend inflation increases
the importance of future marginal costs for current price-setters in a staggered price-setting model.
The greater importance of expectations makes it more difficult for the monetary authority to ensure
stability; in fact, equilibrium determinacy cannot be achieved through reasonable specifications of
nominal interest rate (Taylor) rules at moderate-to-high levels of inflation (for example, at levels
around 4 percent per year). If monetary policymakers have followed these types of policy rules in the
past, this result may explain why moderate-to-high inflation is associated with inflation volatility.
It also suggests a revision to interpretations of the 1970s. At that time, inflation in many countries
was at least moderate, which can contribute to economic instability. The results suggest that some
moderate-inflation countries that have recently adopted inflation targeting may want to commit to low
target inflation rates.
Full paper (621 KB PDF)
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Last update: August 26, 2004