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On Modeling the Effects of Inflation Shocks

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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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Bibliographic Info

Paper provided by Cowles Foundation for Research in Economics, Yale University in its series Cowles Foundation Discussion Papers with number 1300.

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Length: 27 pages
Date of creation: Apr 2001
Date of revision: Mar 2002
Publication status: Published in Contributions to Macroeconomics, Vol. 2, Iss. 1, Article 3
Handle: RePEc:cwl:cwldpp:1300

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Keywords: Macroeconomics; monetary policy;

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References

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  1. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
  2. Fair, Ray C & Taylor, John B, 1983. "Solution and Maximum Likelihood Estimation of Dynamic Nonlinear Rational Expectations Models," Econometrica, Econometric Society, vol. 51(4), pages 1169-85, July.
  3. 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.
  4. John B. Taylor, 1998. "An Historical Analysis of Monetary Policy Rules," NBER Working Papers 6768, National Bureau of Economic Research, Inc.
  5. David Romer, 2000. "Keynesian Macroeconomics without the LM Curve," NBER Working Papers 7461, National Bureau of Economic Research, Inc.
  6. Lucas, Robert Jr, 1976. "Econometric policy evaluation: A critique," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 1(1), pages 19-46, January.
  7. George L. Perry, 1980. "Inflation in Theory and Practice," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 11(1, Tenth ), pages 207-260.
  8. 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.
  9. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1.
  10. 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.
  11. John B. Taylor, 2000. "Teaching Modern Macroeconomics at the Principles Level," American Economic Review, American Economic Association, vol. 90(2), pages 90-94, May.
  12. 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(1), pages 205-244.
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Cited by:
  1. Ray C. Fair, 2006. "Evaluating Inflation Targeting Using a Macroeconometric Model," Cowles Foundation Discussion Papers 1570, Cowles Foundation for Research in Economics, Yale University, revised Mar 2007.
  2. Alistair Dieppe & Jerome Henry & Peter Mc Adam, . "Labour market dynamics in the euro area: A model-based sensitivity analysis," Modeling, Computing, and Mastering Complexity 2003 09, Society for Computational Economics.
  3. Barbara Annicchiarico & Alessandro Piergallini, 2006. "Inflation Shocks and Interest Rate Rules," CEIS Research Paper 85, Tor Vergata University, CEIS.
  4. Ray C. Fair, 2006. "A Comparison of Five Federal Reserve Chairmen: Was Greenspan the Best?," Levine's Bibliography 321307000000000415, UCLA Department of Economics.
  5. repec:ebl:ecbull:v:5:y:2006:i:19:p:1-7 is not listed on IDEAS
  6. Hillinger, Claude & Süssmuth, Bernd, 2008. "The Quantity Theory of Money is Valid. The New Keynesians are Wrong!," Discussion Papers in Economics 6987, University of Munich, Department of Economics.
  7. Corrado, Luisa & Holly, Sean, 2003. "Nonlinear Phillips curves, mixing feedback rules and the distribution of inflation and output," Journal of Economic Dynamics and Control, Elsevier, vol. 28(3), pages 467-492, December.
  8. 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.
  9. Shaun K. Roache & Alexander P. Attie, 2009. "Inflation Hedging for Long-Term Investors," IMF Working Papers 09/90, International Monetary Fund.
  10. 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.

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