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Trend inflation and monetary policy rules: determinacy analysis in New Keynesian model with capital accumulation

Author

Listed:
  • Gerko Elena

    (Department of Economics, London Business School, London, UK)

  • Sossounov Kirill

    (National Research University Higher School of Economics (HSE), Russian Presidential Academy of National Economy and Public Administration (RANEPA))

Abstract

The paper analyzes the effect of positive trend inflation in the framework of a standard New Keynesian model with Calvo price setting and capital accumulation. We are building on the work of Carlstrom and Fuerst (Carlstrom, Charles T., and Timothy S. Fuerst. 2005. “Investment and Interest Rate Policy: A Discrete-Time Analysis.” Journal of Economic Theory 123: 4–20.) and Ascari and Ropele (Ascari, Guido, and Tiziano Ropele. 2007. “Optimal Monetary Policy under Low Trend Inflation.” Journal of Monetary Economics 54 (8): 2568–2583., Ascari, Guido, and Tiziano Ropele. 2009. “Trend Inflation, Taylor Principle, and Indeterminacy.” Journal of Money, Credit and Banking 48 (1): 1557–1584.) who separately considered effects of capital accumulation and trend inflation in a similar context. It is shown that the simultaneous presence of positive trend inflation and capital accumulation greatly affect the determinacy property of equilibrium under this setup. Namely, in the presence of positive trend inflation the determinacy region shrinks, and it is virtually impossible to produce a determinate equilibrium with the Taylor-type rule given a steady state of inflation of more than 5%. Even for a moderate value of 2.5%, the design of the rule that ensures the uniqueness of the equilibrium requires detailed knowledge of the parameters of an economy. We also show that for a large set of plausible parameters, the standard Taylor rule leads to indeterminacy. Alternative monetary policy rules such as interest rate smoothing, output growth targeting and price level targeting are also analyzed. It is shown that the latter improves the determinacy of the model solution, and the best way to guarantee the determinate equilibrium is to use price level targeting in the policy rule.

Suggested Citation

  • Gerko Elena & Sossounov Kirill, 2015. "Trend inflation and monetary policy rules: determinacy analysis in New Keynesian model with capital accumulation," The B.E. Journal of Macroeconomics, De Gruyter, vol. 15(1), pages 413-441, January.
    • Handle: RePEc:bpj:bejmac:v:15:y:2015:i:1:p:29:n:1
    DOI: 10.1515/bejm-2012-0071
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    1. Guido Ascari & Tiziano Ropele, 2009. "Trend Inflation, Taylor Principle, and Indeterminacy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(8), pages 1557-1584, December.
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    4. Olivier Coibion & Yuriy Gorodnichenko, 2011. "Monetary Policy, Trend Inflation, and the Great Moderation: An Alternative Interpretation," American Economic Review, American Economic Association, vol. 101(1), pages 341-370, February.
    5. Mark Bils & Peter J. Klenow, 2004. "Some Evidence on the Importance of Sticky Prices," Journal of Political Economy, University of Chicago Press, vol. 112(5), pages 947-985, October.
    6. Guido Ascari, 2004. "Staggered Prices and Trend Inflation: Some Nuisances," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 7(3), pages 642-667, July.
    7. Ascari, Guido & Ropele, Tiziano, 2007. "Optimal monetary policy under low trend inflation," Journal of Monetary Economics, Elsevier, vol. 54(8), pages 2568-2583, November.
    8. Jordi Galí, 2008. "Introduction to Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New Keynesian Framework," Introductory Chapters, in: Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New Keynesian Framework, Princeton University Press.
    9. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 2005. "Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy," Journal of Political Economy, University of Chicago Press, vol. 113(1), pages 1-45, February.
    10. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
    11. Carlstrom, Charles T. & Fuerst, Timothy S., 2005. "Investment and interest rate policy: a discrete time analysis," Journal of Economic Theory, Elsevier, vol. 123(1), pages 4-20, July.
    12. Jean Boivin & Marc P. Giannoni, 2006. "Has Monetary Policy Become More Effective?," The Review of Economics and Statistics, MIT Press, vol. 88(3), pages 445-462, August.
    13. Gorodnichenko, Yuriy & Shapiro, Matthew D., 2007. "Monetary policy when potential output is uncertain: Understanding the growth gamble of the 1990s," Journal of Monetary Economics, Elsevier, vol. 54(4), pages 1132-1162, May.
    14. Frank Smets & Raf Wouters, 2003. "An Estimated Dynamic Stochastic General Equilibrium Model of the Euro Area," Journal of the European Economic Association, MIT Press, vol. 1(5), pages 1123-1175, September.
    15. Timothy Cogley & Argia M. Sbordone, 2008. "Trend Inflation, Indexation, and Inflation Persistence in the New Keynesian Phillips Curve," American Economic Review, American Economic Association, vol. 98(5), pages 2101-2126, December.
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    Cited by:

    1. Gabriel Karagiannides & Christos Liambas, 2019. "Determinacy and Taylor’s Rule with Different Degrees of Trade Openness in a Semi-New Keynesian Model," Applied Economics and Finance, Redfame publishing, vol. 6(6), pages 43-53, November.
    2. William A. Barnett & Unal Eryilmaz, 2022. "Monetary Policy and Determinacy: An Inquiry in Open Economy New Keynesian Framework," WORKING PAPERS SERIES IN THEORETICAL AND APPLIED ECONOMICS 202203, University of Kansas, Department of Economics.
    3. Guido Ascari & Argia M. Sbordone, 2014. "The Macroeconomics of Trend Inflation," Journal of Economic Literature, American Economic Association, vol. 52(3), pages 679-739, September.
    4. William A. Barnett & Unal Eryilmaz, 2023. "Monetary Policy and Determinacy: An Inquiry into Open Economy New Keynesian Macrodynamics," Open Economies Review, Springer, vol. 34(2), pages 217-253, April.

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    More about this item

    Keywords

    monetary policy; multiple equilibria; Taylor rule;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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