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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
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Handle: RePEc:ecb:ecbwps:20060643
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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. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
  3. Vestin, David, 2000. "Price-level Targeting versus Inflation Targeting in a Forward-looking Model," Working Paper Series 106, Sveriges Riksbank (Central Bank of Sweden).
  4. Athanasios Orphanides, 2001. "Monetary Policy Rules Based on Real-Time Data," American Economic Review, American Economic Association, vol. 91(4), pages 964-985, September.
  5. 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.
  6. Frank Smets & Raf Wouters, 2002. "An estimated dynamic stochastic general equilibrium model of the euro area," Working Paper Research 35, National Bank of Belgium.
  7. James Bullard & Kaushik Mitra, 2002. "Learning about monetary policy rules," Working Papers 2000-001, Federal Reserve Bank of St. Louis.
  8. Ben S. Bernanke & Michael Woodford, 1997. "Inflation Forecasts and Monetary Policy," NBER Working Papers 6157, National Bureau of Economic Research, Inc.
  9. Andrew Levin & John C. Williams, 2000. "The Performance of Forecast-Based Monetary Policy Rules under Model Uncertainty," Econometric Society World Congress 2000 Contributed Papers 1781, Econometric Society.
  10. Lars E.O. Svensson, 2005. "Monetary Policy with Judgment: Forecast Targeting," NBER Working Papers 11167, National Bureau of Economic Research, Inc.
  11. 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.
  12. 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.
  13. 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.
  14. Fiorella De Fiore & Zheng Liu, 2003. "Openness and Equilibrium Determinacy under Interest Rate Rules," Emory Economics 0310, Department of Economics, Emory University (Atlanta).
  15. repec:cup:cbooks:9780521104609 is not listed on IDEAS
  16. Nicoletta Batini & Joseph Pearlman, 2002. "Too Much Too Soon: Instability and Indeterminacy with Forward-Looking Rules," Discussion Papers 08, Monetary Policy Committee Unit, Bank of England.
  17. repec:cup:macdyn:v:6:y:2002:i:1:p:85-110 is not listed on IDEAS
  18. Vestin, David, 2006. "Price-level versus inflation targeting," Journal of Monetary Economics, Elsevier, vol. 53(7), pages 1361-1376, October.
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