Working Paper: CEPR ID: DP3928
Authors: Jess Benhabib; Stephanie Schmitt-Grohe; MartÃn Uribe
Abstract: The existing literature on the stabilizing properties of interest-rate feedback rules has stressed the perils of linking interest rates to forecasts of future inflation. Such rules have been found to give rise to aggregate fluctuations due to self-fulfilling expectations. In response to this concern, a growing literature has focused on the stabilizing properties of interest-rate rules whereby the central bank responds to a measure of past inflation. The consensus view that has emerged is that backward-looking rules contribute to protecting the economy from embarking on expectations-driven fluctuations. A common characteristic of the existing studies that arrive at this conclusion is their focus on local analysis. The contribution of this Paper is to conduct a more global analysis. We find that backward-looking interest-rate feedback rules do not guarantee uniqueness of equilibrium. We present examples in which for plausible parameterizations attracting equilibrium cycles exist. The Paper also contributes to the quest for policy rules that guarantee macroeconomic stability globally. Our analysis indicates that policy rules whereby the interest rate is set as a function of the past interest rate and current inflation are likely to ensure global stability provided that the coefficient on lagged interest rates is greater than unity.
Keywords: Backward-looking Taylor rules; Endogenous cycles; 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 |
|---|---|
| backward-looking interest rate feedback rules (E43) | uniqueness of equilibrium (C62) |
| backward-looking interest rate rules (E43) | macroeconomic instability (E60) |
| active backward-looking rules (G18) | attracting cycles (E32) |
| interest rate set as a function of past interest rates and current inflation (E43) | global stability (C62) |
| coefficient on lagged interest rates > 1 (E43) | global stability (C62) |