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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. Smets, Frank & Wouters, Raf, 2002. "An estimated stochastic dynamic general equilibrium model of the euro area," Working Paper Series 0171, European Central Bank.
  2. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," CEPR Discussion Papers 2139, C.E.P.R. Discussion Papers.
  3. Bullard, James & Mitra, Kaushik, 2002. "Learning about monetary policy rules," Journal of Monetary Economics, Elsevier, vol. 49(6), pages 1105-1129, September.
  4. 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.
  5. 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.
  6. De Fiore, Fiorella & Liu, Zheng, 2002. "Openness and equilibrium determinacy under interest rate rules," Working Paper Series 0173, European Central Bank.
  7. Athanasios Orphanides, 2001. "Monetary Policy Rules Based on Real-Time Data," American Economic Review, American Economic Association, vol. 91(4), pages 964-985, September.
  8. Ben S. Bernanke & Michael Woodford, 1997. "Inflation forecasts and monetary policy," Proceedings, Federal Reserve Bank of Cleveland, pages 653-686.
  9. Alexei Onatski & James H. Stock, 2000. "Robust Monetary Policy Under Model Uncertainty in a Small Model of the U.S. Economy," NBER Working Papers 7490, National Bureau of Economic Research, Inc.
  10. Lars E O Svensson, 2005. "Monetary Policy with Judgment: Forecast Targeting," International Journal of Central Banking, International Journal of Central Banking, vol. 1(1), May.
  11. Levin, Andrew & Wieland, Volker & Williams, John C., 2003. "The performance of forecast-based monetary policy rules under model uncertainty," CFS Working Paper Series 2003/06, Center for Financial Studies (CFS).
  12. Batini, Nicoletta & Justiniano, Alejandro & Levine, Paul & Pearlman, Joseph, 2006. "Robust inflation-forecast-based rules to shield against indeterminacy," Journal of Economic Dynamics and Control, Elsevier, vol. 30(9-10), pages 1491-1526.
  13. Vestin, David, 2006. "Price-level versus inflation targeting," Journal of Monetary Economics, Elsevier, vol. 53(7), pages 1361-1376, October.
  14. Frank Smets & Raf Wouters, 2002. "An estimated dynamic stochastic general equilibrium model of the euro area," Working Paper Research 35, National Bank of Belgium.
  15. repec:cup:macdyn:v:6:y:2002:i:1:p:85-110 is not listed on IDEAS
  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.
  17. Vestin, David, 2000. "Price-level Targeting versus Inflation Targeting in a Forward-looking Model," Working Paper Series 106, Sveriges Riksbank (Central Bank of Sweden).
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