Working Paper: NBER ID: w14621
Authors: Olivier Coibion; Yuriy Gorodnichenko
Abstract: With positive trend inflation, the Taylor principle is not enough to guarantee a determinate equilibrium. We provide new theoretical results on restoring determinacy in New Keynesian models with positive trend inflation and combine these with new empirical findings on the Federal Reserve's reaction function before and after the Volcker disinflation to find that 1) while the Fed likely satisfied the Taylor principle in the pre-Volcker era, the US economy was still subject to self-fulfilling fluctuations in the 1970s, 2) the US economy moved from indeterminacy to determinacy during the Volcker disinflation, and 3) the switch from indeterminacy to determinacy was due to the changes in the Fed's response to macroeconomic variables and the decline in trend inflation during the Volcker disinflation.
Keywords: Monetary Policy; Trend Inflation; Great Moderation; Determinacy; Taylor Principle
JEL Codes: C22; E3; E43; E5
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Insufficient response to inflation (E31) | Indeterminacy in economic outcomes (D89) |
| Changes in the Fed's response to macroeconomic variables + Decline in trend inflation (E31) | Transition from indeterminacy to determinacy (C62) |
| Responding to output growth (O47) | Restore determinacy (C62) |
| Interest smoothing + Price-level targeting (E43) | Enhance determinacy under positive trend inflation (E31) |