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On Modeling the Effects of Inflation Shocks

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Author Info
Ray Fair (Yale University)

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Abstract

A popular model in the literature postulates an interest rate rule, a NAIRU price equation, and an aggregate demand equation in which aggregate demand depends on the real interest rate. In this model a positive inflation shock with the nominal interest rate held constant is explosive because it increases aggregate demand (because the real interest rate is lower), which increases inflation through the price equation, which further increases aggregate demand, and so on. In order for the model to be stable, the nominal interest rate must rise more than inflation, which means that the coefficient on inflation in the interest rate rule must be greater than one. The results in this paper suggest, however, that an inflation shock with the nominal interest rate held constant has a negative effect on real output. There are three reasons. First, the data support the use of nominal rather than real interest rates in aggregate expenditure equations. Second, the evidence suggests that the percentage increase in nominal household wealth from a positive inflation shock is less than the percentage increase in the price level, which is contractionary because of the fall in real wealth. Third, there is evidence that wages lag prices, and so a positive inflation shock results in an initial fall in real wage rates and thus real labor income, which is contractionary. If these three features are true, they imply that a positive inflation shock has a negative effect on aggregate demand even if the nominal interest rate is held constant. Not only does the Fed not have to increase the nominal interest rate more than the increase in inflation for there to be a contraction, it does not have to increase the nominal rate at all!

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Publisher Info
Article provided by Berkeley Electronic Press in its journal Contributions to Macroeconomics.

Volume (Year): 2 (2002)
Issue (Month): 1 ()
Pages: 1045-1045
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Handle: RePEc:bep:maccon:v:2:y:2002:i:1:p:1045-1045

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Related research
Keywords: modern view of macro inflation shocks monetary policy

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Fair, Ray C, 1993. "Testing the Rational Expectations Hypothesis in Macroeconometric Models," Oxford Economic Papers, Oxford University Press, vol. 45(2), pages 169-90, April. [Downloadable!] (restricted)
  2. Richard Clarida & Jordi Gali & Mark Gertler, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December. [Downloadable!] (restricted)
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  3. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules And Macroeconomic Stability: Evidence And Some Theory," The Quarterly Journal of Economics, MIT Press, vol. 115(1), pages 147-180, February. [Downloadable!] (restricted)
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  4. Robert J. Gordon & Stephen R. King, 1982. "The Output Cost of Disinflation in Traditional and Vector Autoregressive Models," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 13(1982-1), pages 205-244. [Downloadable!]
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  5. David Romer, 2000. "Keynesian Macroeconomics without the LM Curve," Journal of Economic Perspectives, American Economic Association, vol. 14(2), pages 149-169, Spring. [Downloadable!] (restricted)
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  6. Ray C. Fair, 2001. "Actual Federal Reserve policy behavior and interest rate rules," Economic Policy Review, Federal Reserve Bank of New York, issue Mar, pages 61-72. [Downloadable!]
  7. David Reifschneider & Robert Tetlow & John Williams, 1999. "Aggregate disturbances, monetary policy, and the macroeconomy: the FRB/US perspective," Federal Reserve Bulletin, Board of Governors of the Federal Reserve System (U.S.), issue Jan, pages 1-19. [Downloadable!]
  8. Fair, Ray C & Taylor, John B, 1990. "Full Information Estimation and Stochastic Simulation of Models with Rational Expectations," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 5(4), pages 381-92, Oct.-Dec.. [Downloadable!] (restricted)
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  9. John B. Taylor, 2000. "Teaching Modern Macroeconomics at the Principles Level," American Economic Review, American Economic Association, vol. 90(2), pages 90-94, May. [Downloadable!] (restricted)
  10. Lucas, Robert Jr, 1976. "Econometric policy evaluation: A critique," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 1(1), pages 19-46, January. [Downloadable!] (restricted)
  11. Ray C. Fair, 2000. "Testing the NAIRU Model for the United States," The Review of Economics and Statistics, MIT Press, vol. 82(1), pages 64-71, February. [Downloadable!] (restricted)
Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Ray C. Fair, 2006. "Evaluating Inflation Targeting Using a Macroeconometric Model," Levine's Bibliography 321307000000000303, UCLA Department of Economics. [Downloadable!]
    Other versions:
  2. Barbara Annicchiarico & Alessandro Piergallini, 2006. "Inflation shocks and interest rate rules," Economics Bulletin, Economics Bulletin, vol. 5(19), pages 1-7. [Downloadable!]
    Other versions:
  3. Paul Turner, 2007. "Some UK evidence on the Forward Looking IS Equation:," Discussion Paper Series 2007_16, Department of Economics, Loughborough University, revised May 2007. [Downloadable!]
  4. Ray C. Fair, 2006. "A Comparison of Five Federal Reserve Chairmen: Was Greenspan the Best?," Cowles Foundation Discussion Papers 1577, Cowles Foundation, Yale University, revised Mar 2007. [Downloadable!]
    Other versions:
  5. Paolo Giordani, 2003. "On Modeling the Effects of Inflation Shocks: Comments and Some Further Evidence," Contributions to Macroeconomics, Berkeley Electronic Press, vol. 3(1), pages 1068-1068. [Downloadable!] (restricted)
  6. W A Razzak, 2002. "Monetary policy and forecasting inflation with and without the output gap," Reserve Bank of New Zealand Discussion Paper Series DP2002/03, Reserve Bank of New Zealand. [Downloadable!]
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