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Inflation forecast-based-rules and indeterminacy: a puzzle and a resolution

  • Levine, Paul
  • McAdam, Peter
  • Pearlman, Joseph G.

We examine an interesting puzzle in monetary economics between what monetary authorities claim (namely to be forward-looking and pre-emptive) 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 which 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, for such rules 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 DSGE model of the Euro-area. JEL Classification: E52, E37, E58

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Paper provided by European Central Bank in its series Working Paper Series with number 0643.

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Date of creation: Jun 2006
Date of revision:
Handle: RePEc:ecb:ecbwps:20060643
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  1. Kaushik Mitra & James Bullard, . "Learning About Monetary Policy Rules," Discussion Papers 00/41, Department of Economics, University of York.
  2. 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.
  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. 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. Ben S. Bernanke & Michael Woodford, 1997. "Inflation forecasts and monetary policy," Proceedings, Federal Reserve Bank of Cleveland, pages 653-686.
  6. 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.
  7. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
  8. Smets, Frank & Wouters, Raf, 2002. "An estimated stochastic dynamic general equilibrium model of the euro area," Working Paper Series 0171, European Central Bank.
  9. 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).
  10. Alexei Onatski & James H. Stock, 1999. "Robust monetary policy under model uncertainty in a small model of the U.S. economy," Proceedings, Federal Reserve Bank of San Francisco.
  11. Athanasios Orphanides, 2001. "Monetary Policy Rules Based on Real-Time Data," American Economic Review, American Economic Association, vol. 91(4), pages 964-985, September.
  12. 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.
  13. repec:cup:macdyn:v:6:y:2002:i:1:p:85-110 is not listed on IDEAS
  14. De Fiore, Fiorella & Liu, Zheng, 2002. "Openness and equilibrium determinacy under interest rate rules," Working Paper Series 0173, European Central Bank.
  15. Vestin, David, 2006. "Price-level versus inflation targeting," Journal of Monetary Economics, Elsevier, vol. 53(7), pages 1361-1376, October.
  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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