Working Paper: NBER ID: w13409
Authors: John H. Cochrane
Abstract: The new-Keynesian, Taylor-rule theory of inflation determination relies on explosive dynamics. By raising interest rates in response to inflation, the Fed induces ever-larger inflation or deflation, unless inflation jumps to one particular value on each date. However, economics does not rule out inflationary or deflationary equilibria. Attempts to fix this problem assume that people believe the government will choose to blow up the economy if alternative equilibria emerge, by following policies we usually consider impossible. Therefore, inflation is just as indeterminate under "active" interest rate targets as it is under fixed interest rate targets. \n\nIf one accepts the new-Keynesian solution, the parameters of the Taylor rule relating interest rates to inflation and other variables are not identified without unrealistic assumptions. Thus, Taylor rule regressions cannot be used to argue that the Fed conquered inflation by moving from a "passive" to an "active" policy in the early 1980s.
Keywords: Taylor rule; inflation determination; New-Keynesian economics
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 |
|---|---|
| higher inflation (E31) | higher interest rates (E43) |
| higher interest rates (E43) | future inflation (E31) |
| higher inflation (E31) | higher future inflation (E31) |
| Taylor rule (E43) | inflation indeterminacy (E31) |
| parameters of the Fed's reaction function not identified (E19) | regression evidence cannot demonstrate effectiveness (C90) |
| New-Keynesian models do not establish clear causal link between inflation and interest rates (E12) | dynamics influenced by multiple equilibria (D50) |