Working Paper: CEPR ID: DP7960
Authors: Patrick Minford; Naveen Srinivasan
Abstract: The New-Keynesian Taylor-Rule model of inflation determination with no role for money is incomplete. As Cochrane (2007a, b) argues, it has no credible mechanism for ruling out bubbles (or deal with the non-uniqueness problem that arises when the Taylor principle is violated) and as a result fails to provide a reason for private agents to pick a unique stable path. We propose a way forward. Our proposal is in effect that the New-Keynesian model should be formulated with a money demand and money supply function. It should also embody a terminal condition for money supply behaviour. If indeterminacy of stable (or unstable paths) occurred the central bank would switch to a money supply rule explicitly designed to stop it via the terminal condition. This would be therefore a `threat/trigger strategy' complementing the Taylor Rule --- only to be invoked if inflation misbehaved. Thus we answer the criticisms levelled at the Taylor Rule that it has no credible mechanism for dealing with these issues. However it does imply that money cannot be avoided in the new Keynesian set-up, contrary to Woodford (2008).
Keywords: determinacy; money supply; New Keynesian; Taylor rule; terminal condition
JEL Codes: E31; E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Inclusion of money supply rules (E51) | More stable inflation outcomes (E31) |
| Introduction of money demand and supply function (E41) | Achieve determinacy in inflation paths (E31) |
| Central bank's commitment to a money supply rule (E52) | Prevent undesirable inflation outcomes (E31) |
| Existence of a terminal condition (C62) | Influences private agents' expectations regarding inflation paths (D84) |
| Traditional reliance on the Taylor rule alone (E61) | Insufficient to stabilize inflation paths (E63) |