Working Paper: NBER ID: w21614
Authors: Mariana Garcíaschmidt; Michael Woodford
Abstract: We illustrate a pitfall that can result from the common practice of assessing alternative monetary policies purely by considering the perfect foresight equilibria (PFE) consistent with the proposed rule. In a standard New Keynesian model, such analysis may seem to support the “Neo-Fisherian” proposition according to which low nominal interest rates can cause inflation to be lower. We propose instead an explicit cognitive process by which agents may form their expectations of future endogenous variables. Under some circumstances, a PFE can arise as a limiting case of our more general concept of reflective equilibrium, when the process of reflection is pursued sufficiently far. But we show that an announced intention to fix the nominal interest rate for a long enough period of time creates a situation in which reflective equilibrium need not resemble any PFE. In our view, this makes PFE predictions not plausible outcomes in the case of such policies. Our alternative approach implies that a commitment to keep interest rates low should raise inflation and output, though by less than some PFE analyses apply.
Keywords: Low Interest Rates; Inflation; Monetary Policy; Perfect Foresight; Reflective Equilibrium
JEL Codes: E31; E43; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| low nominal interest rates (E43) | higher inflation (E31) |
| low nominal interest rates (E43) | higher output (E23) |
| commitment to low interest rates (E43) | higher inflation (E31) |
| commitment to low interest rates (E43) | higher output (E23) |
| expectation formation (D84) | higher inflation (E31) |
| expectation formation (D84) | higher output (E23) |
| PFE predictions (E17) | lower inflation (E31) |