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The Perils of Taylor Rules

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  • Benhabib, Jess
  • Schmitt-Grohe, Stephanie
  • Uribe, Martin

Abstract

Since John Taylor's (1993) seminal paper, a large literature has argued that active interest rate feedback rules, that is, rules that respond to increases in inflation with a more than one-for-one increase in the nominal interest rate, are stabilizing. In this paper, we argue that once the zero bound on nominal interest rates is taken into account, active interest rate feedback rules can easily lead to unexpected consequences. Specifically, we show that even if the steady state at which monetary policy is active, is locally the unique equilibrium, typically there exists an infinite number of equilibrium trajectories originating arbitrarily close to that steady state, that converge to a liquidity trap, that is, a steady state in which the nominal interest rate is near zero and inflation is possibly negative.
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Suggested Citation

  • Benhabib, Jess & Schmitt-Grohe, Stephanie & Uribe, Martin, 1998. "The Perils of Taylor Rules," Working Papers 98-37, C.V. Starr Center for Applied Economics, New York University.
  • Handle: RePEc:cvs:starer:98-37
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    More about this item

    Keywords

    interest rate feedback rules; zero bound on nominal rates; liquidity traps; multiple equilibria;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy

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