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Inflation-Forecast-Based Rules and Indeterminacy: A Puzzle and a Resolution

  • Paul Levine

    (University of Surrey)

  • Peter McAdam

    (European Central Bank)

  • Joseph Pearlman

    (London Metropolitan University)

We examine an interesting puzzle in monetary economics between what monetary authorities claim (namely, to be forward looking and preemptive) and the poor stabilization properties routinely reported for forecast-based rules. Our resolution is that central banks should be viewed as following 'Calvo-type' inflation-forecast-based (IFB) interest rate rules that depend on a discounted sum of current and future rates of inflation. Such rules might be regarded as both within the legal frameworks and potentially mimicking central bankers' practice. We find that Calvo-type IFB interest rate rules are, first, less prone to indeterminacy than standard rules with a finite forward horizon. Second, in difference form, the indeterminacy problem disappears altogether. Third, optimized forms have good stabilization properties as they become more forward looking, a property that sharply contrasts that of standard IFB rules. Fourth, they appear data coherent when incorporated into a well-known estimated dynamic stochastic general equilibrium (DSGE) model of the euro area.

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Article provided by International Journal of Central Banking in its journal International Journal of Central Banking.

Volume (Year): 3 (2007)
Issue (Month): 4 (December)
Pages: 77-110

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Handle: RePEc:ijc:ijcjou:y:2007:q:4:a:3
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  1. Vestin, David, 2006. "Price-level versus inflation targeting," Journal of Monetary Economics, Elsevier, vol. 53(7), pages 1361-1376, October.
  2. Nicoletta Batini & Joe Pearlman, 2002. "Too Much Too Soon: Instability and Indeterminacy with Forward-Looking Rules," Computing in Economics and Finance 2002 182, Society for Computational Economics.
  3. Frank Smets & Raf Wouters, 2002. "An estimated dynamic stochastic general equilibrium model of the euro area," Working Paper Research 35, National Bank of Belgium.
  4. Andrew Levin & Volker Wieland & John C. Williams, 2001. "The performance of forecast-based monetary policy rules under model uncertainty," Finance and Economics Discussion Series 2001-39, Board of Governors of the Federal Reserve System (U.S.).
  5. Onatski, Alexei & Stock, James H., 2002. "Robust Monetary Policy Under Model Uncertainty In A Small Model Of The U.S. Economy," Macroeconomic Dynamics, Cambridge University Press, vol. 6(01), pages 85-110, February.
  6. Bernanke, Ben S & Woodford, Michael, 1997. "Inflation Forecasts and Monetary Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(4), pages 653-84, November.
  7. Athanasios Orphanides, 1998. "Monetary policy rules based on real-time data," Finance and Economics Discussion Series 1998-03, Board of Governors of the Federal Reserve System (U.S.).
  8. Kaushik Mitra & James Bullard, . "Learning About Monetary Policy Rules," Discussion Papers 00/41, Department of Economics, University of York.
  9. Nicoletta Batini & Alejandro Justiniano & Paul Levine & Joseph Pearlman, 2004. "Robust Inflation-Forecast-Based Rules to Shield against Indeterminacy," School of Economics Discussion Papers 0804, School of Economics, University of Surrey.
  10. Fiorella De Fiore & Zheng Liu, 2003. "Openness and Equilibrium Determinacy under Interest Rate Rules," Emory Economics 0310, Department of Economics, Emory University (Atlanta).
  11. Richard Clarida & Jordi Gali & Mark Gertler, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," NBER Working Papers 7147, National Bureau of Economic Research, Inc.
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  13. Smets, Frank & Wouters, Raf, 2002. "An estimated stochastic dynamic general equilibrium model of the euro area," Working Paper Series 0171, European Central Bank.
  14. Lars E.O. Svensson, 2005. "Monetary Policy with Judgment: Forecast Targeting," NBER Working Papers 11167, National Bureau of Economic Research, Inc.
  15. Vestin, David, 2000. "Price-level Targeting versus Inflation Targeting in a Forward-looking Model," Working Paper Series 106, Sveriges Riksbank (Central Bank of Sweden).
  16. Sargent, Thomas J & Wallace, Neil, 1975. ""Rational" Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule," Journal of Political Economy, University of Chicago Press, vol. 83(2), pages 241-54, April.
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  18. Michael Woodford, 1999. "Commentary : how should monetary policy be conducted in an era of price stability?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 277-316.
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