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Inflation Determination with Taylor Rules: Is New Keynesian Analysis Critically Flawed?

  • Bennett T. McCallum

Cochrane (2007) has strongly questioned the basic economic logic of current mainstream monetary policy analysis, arguing that the standard notion --that "determinacy" of a rational expectations (RE) equilibrium suffices to imply that stable inflation behavior will be generated -- is incorrect. This is because New Keynesian (NK) models are typically consistent with the existence of RE paths with explosive inflation rates (in addition to one or more stable paths) that normally do not imply explosions in real variables relevant for transversality conditions. Consequently, the usual logic does not imply the absence of explosive inflation. That result does not, however, justify negative conclusions about NK analysis. For there is a different criterion that is logically satisfactory for the purpose at hand. This is the requirement that, to be plausible, a RE solution must satisfy the property of least-squares learnability. Adoption of this criterion, which should be attractive to analysts concerned with actual monetary policy, serves to justify in principle the bulk of current mainstream analysis.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 14534.

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Date of creation: Dec 2008
Date of revision:
Publication status: published as McCallum, Bennett T., 2009. "Inflation determination with Taylor rules: Is new-Keynesian analysis critically flawed?," Journal of Monetary Economics, Elsevier, vol. 56(8), pages 1101-1108, November.
Handle: RePEc:nbr:nberwo:14534
Note: EFG ME
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  1. Jo Anna Gray, 1982. "Dynamic instability in rational expectations models: an attempt to clarify," International Finance Discussion Papers 197, Board of Governors of the Federal Reserve System (U.S.).
  2. Robert G. King & Alexander L. Wolman, 1996. "Inflation Targeting in a St. Louis Model of the 21st Century," NBER Working Papers 5507, National Bureau of Economic Research, Inc.
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  12. Clarida, R. & Gali, J. & Gertler, M., 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and some Theory," Working Papers 98-01, C.V. Starr Center for Applied Economics, New York University.
  13. Bennett T. McCallum, 2001. "Monetary Policy Analysis in Models Without Money," NBER Working Papers 8174, National Bureau of Economic Research, Inc.
  14. McCallum, Bennett T., 2007. "E-stability vis-a-vis determinacy results for a broad class of linear rational expectations models," Journal of Economic Dynamics and Control, Elsevier, vol. 31(4), pages 1376-1391, April.
  15. Evans, George W & Honkapohja, Seppo, 1998. "Economic Dynamics with Learning: New Stability Results," Review of Economic Studies, Wiley Blackwell, vol. 65(1), pages 23-44, January.
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  17. Evans, George W. & Honkapohja, Seppo, 1999. "Learning dynamics," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 7, pages 449-542 Elsevier.
  18. Taylor, John B., 1999. "The robustness and efficiency of monetary policy rules as guidelines for interest rate setting by the European central bank," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 655-679, June.
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