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Where Is the Natural Rate? Rational Policy Mistakes and Persistent Deviations of Inflation from Target

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  • Reis Ricardo

    () (Harvard University)

Abstract

Empirical research has shown that there is large uncertainty concerning the value of the natural rate of unemployment at any point in time. I incorporate this feature in a model of monetary policy where the policymaker targets an inflation rate and the natural rate of unemployment and solve for the optimal policy. Two interesting results emerge. First, under a realistic shock profile, the model generates long-lasting deviations of inflation from target, providing an alternative (but also a complement) to the popular Barro-Gordon framework. Second, the economy exhibits large inflation persistence and can have very rich inflation dynamics. The model is able to account for approximately one third of the increase in inflation in the United States in the late 1970s, and suggests an explanation for the low inflation of the late 1990s. Moreover, I present empirical evidence for the United States and other countries that support the model including a new empirical finding: across countries there is a positive statistical relation between the persistence of unemployment and the persistence of inflation.

Suggested Citation

  • Reis Ricardo, 2003. "Where Is the Natural Rate? Rational Policy Mistakes and Persistent Deviations of Inflation from Target," The B.E. Journal of Macroeconomics, De Gruyter, vol. 3(1), pages 1-40, September.
  • Handle: RePEc:bpj:bejmac:v:advances.3:y:2003:i:1:n:1
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    Cited by:

    1. Guido Lorenzoni, 2009. "A Theory of Demand Shocks," American Economic Review, American Economic Association, vol. 99(5), pages 2050-2084, December.
    2. Sharon Kozicki & P. Tinsley, 2006. "Minding the Gap: Central Bank Estimates of the Unemployment Natural Rate," Computational Economics, Springer;Society for Computational Economics, vol. 27(2), pages 295-327, May.
    3. Alan S. Blinder & Ricardo Reis, 2005. "Understanding the Greenspan standard," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, issue Aug, pages 11-96.
    4. Brian Snowdon, 2007. "The New Classical Counter-Revolution: False Path or Illuminating Complement?," Eastern Economic Journal, Eastern Economic Association, vol. 33(4), pages 541-562, Fall.
    5. Ellison, Martin & Yates, Tony, 2007. "Escaping Nash and Volatile Inflation," CEPR Discussion Papers 6483, C.E.P.R. Discussion Papers.
    6. Richard Mash, 2004. "Optimising Microfoundations for Inflation Persistence," Economics Series Working Papers 183, University of Oxford, Department of Economics.
    7. Gersbach, Hans & Hahn, Volker, 2006. "Signaling And Commitment: Monetary Versus Inflation Targeting," Macroeconomic Dynamics, Cambridge University Press, vol. 10(05), pages 595-624, November.
    8. Queijo von Heideken, Virginia, 2008. "Monetary Policy Regimes and the Volatility of Long-Term Interest Rates," Working Paper Series 220, Sveriges Riksbank (Central Bank of Sweden).
    9. Guido Lorenzoni, 2007. "News Shocks and Optimal Monetary Policy," NBER Working Papers 12898, National Bureau of Economic Research, Inc.

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