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Is Forward-Looking Inflation Targeting Destabilizing? The Role of Policy's Response to Current Output under Endogenous Investment

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  • Kevin X.D. Huang

    ()
    (Department of Economics, Vanderbilt University)

  • Qinglai Meng

    ()
    (Department of Economics, Chinese University of Hong Kong)

Abstract

In sticky price models with endogenous investment, virtually all monetary policy rules that set a nominal interest rate in response solely to future inflation induce real indeterminacy of equilibrium. Applying the Samuelson-Farebrother conditions, we obtain a necessary and sufficient condition for local real determinacy, which reveals that increasing price stickiness or letting policy respond also to current output may help ensure a unique equilibrium. We find that the first channel by itself has a quantitatively negligible effect and almost all strict inflation-targeting rules lead to indeterminacy, whether with higher price stickiness or overall stickiness by incorporating firm-specific capital, sticky wages, or both. The effect of the second avenue depends on labor supply elasticity and stickiness. With high labor supply elasticity and price stickiness, indeterminacy is much less likely to occur as policy also responds to output. With estimated labor supply elasticity or empirically reasonable price stickiness, policy's response to output helps little in ensuring determinacy; even incorporating firm-specific capital makes only a marginal improvement. Incorporating sticky wages, on the other hand, greatly enhances the role of policy's response to output in ensuring determinacy. With both sticky wages and firm-specific capital incorporated, even a tiny response of policy to current output can render equilibrium determinate for a wide range of response of policy to future inflation.

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Paper provided by Vanderbilt University Department of Economics in its series Vanderbilt University Department of Economics Working Papers with number 0704.

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Date of creation: Feb 2007
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Handle: RePEc:van:wpaper:0704

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Keywords: Forward-looking inflation targeting; current output; sticky prices; sticky wages; firm-specific capital; endogenous investment; indeterminacy; Samuelson-Farebrother conditions;

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Cited by:
  1. Stephen McKnight, 2011. "Investment and interest rate policy in the open economy," Oxford Economic Papers, Oxford University Press, vol. 63(4), pages 673-699, December.
  2. Takushi Kurozumi & Willem Van Zandweghe, 2011. "Determinacy under Inflation Targeting Interest Rate Policy in a Sticky Price Model with Investment (and Labor Bargaining)," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 43(5), pages 1019-1033, 08.
  3. Tommy Sveen & Lutz Weinke, 2010. "The Taylor Principle in a medium-scale macroeconomic model," Working Paper, Norges Bank 2010/09, Norges Bank.
  4. Buffie, Edward F., 2013. "The Taylor principle fights back, Part I," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 37(12), pages 2771-2795.
  5. Vadim Khramov, 2012. "Assessing Dsge Models with Capital Accumulation and Indeterminacy," IMF Working Papers 12/83, International Monetary Fund.
  6. Kurozumi, Takushi & Van Zandweghe, Willem, 2008. "Investment, interest rate policy, and equilibrium stability," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 32(5), pages 1489-1516, May.

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