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The inflation-output trade-off revisited

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  • Gauti Eggertsson
  • Marc P. Giannoni

Abstract

A rich literature from the 1970s shows that as inflation expectations become more and more ingrained, monetary policy loses its stimulative effect. In the extreme, with perfectly anticipated inflation, there is no trade-off between inflation and output. A recent literature on the interest-rate zero lower bound, however, suggests there may be some benefits from anticipated inflation when the economy is in a liquidity trap. In this paper, we reconcile these two views by showing that while it is true that, at positive interest rates, the greater the anticipated inflation the less stimulative are the effects, the opposite holds true at the zero bound. Indeed, at the zero bound, the more the public anticipates inflation, the greater is the expansionary effect of inflation on output. This leads us to revisit the trade-off between inflation and output and to show how radically it changes in the face of demand shocks large enough to bring the economy into a liquidity trap. Instead of vanishing once inflation becomes anticipated, the trade-off between inflation and output increases substantially and may become arbitrarily large. In such cases, raising the inflation target in a liquidity trap can be very stimulative.

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Bibliographic Info

Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 608.

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Date of creation: 2013
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Handle: RePEc:fip:fednsr:608

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Keywords: Inflation (Finance) ; Interest rates ; Liquidity (Economics) ; Supply and demand;

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  1. Saroj Bhattarai & Gauti Eggertsson & Raphael Schoenle, 2014. "Is Increased Price Flexibility Stabilizing? Redux," NBER Working Papers 19886, National Bureau of Economic Research, Inc.
  2. Barro, Robert J & Gordon, David B, 1983. "A Positive Theory of Monetary Policy in a Natural Rate Model," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 589-610, August.
  3. Lawrence Christiano & Martin Eichenbaum & Sergio Rebelo, 2009. "When is the government spending multiplier large?," NBER Working Papers 15394, National Bureau of Economic Research, Inc.
  4. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
  5. Paul R. Krugman, 1998. "It's Baaack: Japan's Slump and the Return of the Liquidity Trap," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(2), pages 137-206.
  6. Barry J. Eichengreen & Jeffrey Sachs, 1986. "Exchange Rates and Economic Recovery in the 1930s," NBER Working Papers 1498, National Bureau of Economic Research, Inc.
  7. Marvin Goodfriend & Robert G. King, 2005. "The Incredible Volcker Disinflation," Boston University - Department of Economics - Macroeconomics Working Papers Series WP2005-007, Boston University - Department of Economics.
  8. Benhabib, Jess & Schmitt-Grohé, Stephanie & Uribe, Martín, 1999. "The Perils of Taylor Rules," CEPR Discussion Papers 2314, C.E.P.R. Discussion Papers.
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