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Endogenous Cycles in Optimal Monetary Policy with a Nonlinear Phillips Curve

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Author Info
Gomes, O. (IPL, Lisbon)
Mendes, D. A. (ISCTE, Lisbon)
Mendes, V. P. (ISCTE, Lisbon)
Sousa Ramos, J. (IST, Lisbon)

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Abstract

There is by now a large consensus in modern monetary policy. This consensus has been built upon a dynamic general equilibrium model of optimal monetary policy with sticky prices a la Calvo and forward looking behavior. In this paper we extend this standard model by introducing nonlinearity into the Phillips curve. As the linear Phillips curve may be questioned on theoretical grounds and seems not to be favoured by empirical evidence, a similar procedure has already been undertaken in a series papers over the last few years, e.g., Schaling (1999), Semmler and Zhang (2004), Nobay and Peel (2000), Tambakis (1999), and Dolado et al. (2004). However, these papers were mainly concerned with the analysis of the problem of inflation bias, by deriving an interest rate rule which is nonlinear, leaving the issues of stability and the possible existence of endogenous cycles in such a framework mostly overlooked. Under the specific form of nonlinearity proposed in our paper (which allows for both convexity and concavity and secures closed form solutions), we show that the introduction of a nonlinear Phillips curve into a fully deterministic structure of the standard model produces significant changes to the major conclusions regarding stability and the efficiency of monetary policy in the standard model. We should emphasize the following main results: (i) instead of a unique fixed point we end up with multiple equilibria; (ii) instead of saddle--path stability, for different sets of parameter values we may have saddle stability, totally unstable and chaotic fixed points (endogenous cycles); (iii) for certain degrees of convexity and/or concavity of the Phillips curve, where endogenous fluctuations arise, one is able to encounter various results that seem interesting. Firstly, when the Central Bank pays attention essentially to inflation targeting, the inflation rate may have a lower mean and is certainly less volatile; secondly, for changes in the degree of price stickiness the results are not are clear cut as in the previous case, however, we can also observe that when such stickiness is high the inflation rate tends to display a somewhat larger mean and also higher volatility; and thirdly, it shows that the target values for inflation and the output gap (π^,x^), both crucially affect the dynamics of the economy in terms of average values and volatility of the endogenous variables --- e.g., the higher the target value of the output gap chosen by the Central Bank, the higher is the inflation rate and its volatility --- while in the linear case only the π^ does so (obviously, only affecting in this case the level of the endogenous variables). Moreover, the existence of endogenous cycles due to chaotic motion may raise serious questions about whether the old dictum of monetary policy (that the Central Bank should conduct policy with discretion instead of commitment) is not still very much in the business of monetary policy.

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Paper provided by Money Macro and Finance Research Group in its series Money Macro and Finance (MMF) Research Group Conference 2006 with number 139.

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Date of creation: 02 Feb 2007
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Handle: RePEc:mmf:mmfc06:139

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Related research
Keywords: Optimal monetary policy Interest Rate Rules Nonlinear Phillips Curve Endogenous Fluctuations and Stabilization

Find related papers by JEL classification:
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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