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Price Level Determinacy with an Interest Rate Policy Rule and Rational Expectations

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  • Bennett T. McCallum

Abstract

This paper reconsiders a result obtained by Sargent and Wallace, namely, that price level indeterminacy obtains in their well-known model if the monetary authorities adopt a policy feedback rule for the interest rate rather than the money stock. Since the Federal Reserve seems often to have used the federal funds rate as its operating instrument, with the money stack determined by the quantity demanded, this result suggests that the Sargent-Wallace model -- as well as others incorporating rational expectations -- is inconsistent with U.S. experience. It is here shown, however, that the indeterminacy result vanishes if the interest rate rule is chosen so as to have some desired effect on the expected quantity of money demanded. This revised conclusion holds even if considerable weight is given, in the choice of a rule, to the aim of smoothing interest rate fluctuations.

Suggested Citation

  • Bennett T. McCallum, 1980. "Price Level Determinacy with an Interest Rate Policy Rule and Rational Expectations," NBER Working Papers 0559, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:0559
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    1. Barro, Robert J, 1974. "Are Government Bonds Net Wealth?," Journal of Political Economy, University of Chicago Press, vol. 82(6), pages 1095-1117, Nov.-Dec..
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    6. John H. Kareken & Preston J. Miller, 1976. "The policy procedure of the FOMC: a critique," Working Papers 63, Federal Reserve Bank of Minneapolis.
    7. Lucas, Robert E, Jr, 1973. "Some International Evidence on Output-Inflation Tradeoffs," American Economic Review, American Economic Association, vol. 63(3), pages 326-334, June.
    8. Flood, Robert P & Garber, Peter M, 1980. "Market Fundamentals versus Price-Level Bubbles: The First Tests," Journal of Political Economy, University of Chicago Press, vol. 88(4), pages 745-770, August.
    9. Volcker, Paul A., 1978. "The role of monetary targets in an age of inflation," Journal of Monetary Economics, Elsevier, vol. 4(2), pages 329-339, April.
    10. Phelps, Edmund S & Taylor, John B, 1977. "Stabilizing Powers of Monetary Policy under Rational Expectations," Journal of Political Economy, University of Chicago Press, vol. 85(1), pages 163-190, February.
    11. McCallum, Bennett T, 1978. "Price Level Adjustments and the Rational Expectations Approach to Macroeconomic Stabilization Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 10(4), pages 418-436, November.
    12. Poole, William, 1975. "The Making of Monetary Policy: Description and Analysis," Economic Inquiry, Western Economic Association International, vol. 13(2), pages 253-265, June.
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