Chronic Inflation in the New Keynesian Model

The New Keynesian model became the workhorse for the analysis of monetary policy. This framework contains two equations and three variables, inflation, output gap and the nominal rate of interest. To close the model it uses an interest rate rule, such as a Taylor rule, as a monetary policy rule, since most central banks follow the strategy of targeting inflation. In chronic inflation countries, money issue finances the fiscal deficit. In such an environment, the strategy of the central bank is to collect inflation tax from the public and to give the proceeds to the government. Thus, the specification of the monetary policy rule depends on the size of the fiscal deficit financed by money and the policy instrument is not the rate of interest but the rate of growth of money. My main goal in this chapter is to analyze the New Keynesian model under this monetary policy rule. This chapter is organized as follows: Sect. 2 presents the model specification. Section 3 analyzes the dynamical system, its equilibrium and stability. Section 4 provides an empirical assessment of the parameters that determine the model’s properties. Section 5 gives the concluding remarks.