Working Paper: NBER ID: w22009
Authors: Narayana R. Kocherlakota
Abstract: A large body of recent empirical work on inflation dynamics documents that current real variables (like unemployment or output gaps) have little explanatory power for future inflation. Motivated by these findings, I explore the properties of a wide class of models in which inflation expectations respond little, if at all, to real economic conditions. In this general context, I examine Markov equilibria to games in which the relevant forcing processes are Markov chains and the central bank chooses a short- term nominal interest rate at each date subject to a lower bound. I construct a simple numerical algorithm to solve for such Markov equilibria. I apply the algorithm to a numerical example. In the example, the economy can experience long periods of what looks like secular stagnation because households believe that there is a significant risk of a crisis (that is, a sharp decline in economic activity). Within the example, there are large benefits to being able to reduce the lower bound on the short-term nominal interest rate by as little as fifty basis points.
Keywords: Inflation Expectations; Markov Chains; Monetary Policy; Zero Lower Bound
JEL Codes: E31; E32; E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| central bank's nominal interest rate decisions (E52) | inflation expectations (E31) |
| inflation expectations (E31) | economic activity (E20) |
| central bank's nominal interest rate decisions (E52) | economic activity (E20) |
| inflation expectations (E31) | inflation outcomes (E31) |
| relaxation of the zero lower bound (E43) | economic efficiency (D61) |
| economic conditions (E66) | inflation expectations (E31) |
| economic crises (G01) | inflation expectations (E31) |