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Regime changes and monetary stagflation

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  • Edward S. Knotek II

Abstract

This paper examines whether monetary shocks can consistently generate stagflation in a dynamic, stochastic setting. I assume that the monetary authority can induce transitory shocks and longer-lasting monetary regime changes in its operating instrument. Firms cannot distinguish between these shocks and must learn about them using a signal extraction problem. The possibility of changes in the monetary regime greatly improves the ability of money to generate stagflation. This is true whether the regime actually changes or not. If the monetary regime changes on average once every ten years, stagflation occurs in 76% of model simulations. The intuition for this result is simple: increased output volatility due to learning coupled with inflation inertia produce conditions conducive to the emergence of stagflation. The incidence of stagflation can be reduced by a stable, transparent central bank.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Kansas City in its series Research Working Paper with number RWP 06-05.

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Date of creation: 2006
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Handle: RePEc:fip:fedkrw:rwp06-05

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Keywords: Inflation (Finance) ; Recessions ; Monetary policy;

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