Working Paper: NBER ID: w14534
Authors: Bennett T. McCallum
Abstract: Cochrane (2007) has strongly questioned the basic economic logic of current mainstream monetary policy analysis, arguing that the standard notion --that "determinacy" of a rational expectations (RE) equilibrium suffices to imply that stable inflation behavior will be generated -- is incorrect. This is because New Keynesian (NK) models are typically consistent with the existence of RE paths with explosive inflation rates (in addition to one or more stable paths) that normally do not imply explosions in real variables relevant for transversality conditions. Consequently, the usual logic does not imply the absence of explosive inflation. That result does not, however, justify negative conclusions about NK analysis. For there is a different criterion that is logically satisfactory for the purpose at hand. This is the requirement that, to be plausible, a RE solution must satisfy the property of least-squares learnability. Adoption of this criterion, which should be attractive to analysts concerned with actual monetary policy, serves to justify in principle the bulk of current mainstream analysis.
Keywords: Taylor Principle; New Keynesian Models; Inflation Determination; Least-Squares Learnability
JEL Codes: E4; E5; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Taylor principle does not guarantee stable inflation behavior (E31) | explosive inflation paths can exist alongside stable paths (E31) |
| assumption of determinacy does not preclude explosive inflation (E19) | traditional monetary policy analysis may be fundamentally flawed (E19) |
| for a rational expectations equilibrium to be plausible (D84) | it must satisfy the condition of least-squares learnability (C51) |
| if a solution is not learnable (C52) | it is unlikely to represent actual economic behavior (D89) |