Working Paper: CEPR ID: DP2316
Authors: Jess Benhabib; Stephanie Schmitt-Grohe; Martin Uribe
Abstract: In this paper, we characterize conditions under which interest rate feedback rules that set the nominal interest rate as an increasing function of the inflation rate induce aggregate instability by generating multiple equilibria. We show that these conditions depend not only on the monetary-fiscal regime (as emphasized in the fiscal theory of the price level) but also on the way in which money is assumed to enter preferences and technology. We provide a number of examples in which, contrary to what is commonly believed, active monetary policy in combination with a fiscal policy that preserves government solvency under all circumstances gives rise to multiple equilibria, and passive monetary policy renders the equilibrium unique. Our general conclusion holds in flexible- and sticky-price environments as well as under backward- or forward-looking interest rate feedback rules.
Keywords: interest rate feedback rules; multiple equilibria; sticky prices
JEL Codes: E31; E52; E63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| monetary policy (E52) | macroeconomic stability (E60) |
| fiscal policy (E62) | macroeconomic stability (E60) |
| interest rate feedback rules (E43) | aggregate instability (E10) |
| monetary policy (E52) | equilibrium determinacy (C62) |
| money enters production function (E23) | multiple equilibria (D50) |
| active monetary policy (E63) | multiple equilibria (D50) |
| passive monetary policy (E63) | unique equilibria (C62) |
| integration of money into preferences and technology (E41) | aggregate stability (E10) |