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Learning the Fiscal Monetary Interaction under Trend Infl?ation

  • Anna Florio


    (Dipartimento di Ingeneria Gestionale, Politecnico di Milano)

  • Alessandro Gobbi


    (Department of Economics and Finance, Universita Cattolica del Sacro Cuore)

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    What are the effects of a higher inflation target on the determinacy properties under alternative monetary/fiscal policy mixes in New Keynesian models? Would it be more difficult for the central bank to stabilize inflation expectations if the inflation target is raised? What role for central bank transparency? We find that trend inflation does not affect determinacy as long as monetary policy is passive. Conversely, an active central bank should fight inflation more strongly with higher trend inflation, in order to guarantee the determinacy of the AM/PF equilibrium. Furthermore, this equilibrium, if determinate, is always E-stable under transparency. In the AF/PM case the equilibrium is always determinate and E-stable under both transparency and opacity. We find the degree of price stickiness to be a crucial structural parameter. In particular, in a low price rigidity country, say the United States, adhering to the Taylor principle is a sufficient condition for equilibrium determinacy under the AM/PF regime, irrespective of the level of trend inflation. Still, the central bank must be transparent to stabilize expectations. On the contrary, in a high price rigidity economy, say Europe, to have determinacy under AM/PF mix, the inflation target cannot be larger than 2% but the central bank needs not to be transparent to stabilize expectations. Furthermore, high rigidity makes non-Ricardian policies less E-stable.

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    Paper provided by University of Pavia, Department of Economics and Management in its series DEM Working Papers Series with number 068.

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    Length: 35 pages
    Date of creation: Feb 2014
    Date of revision:
    Handle: RePEc:pav:demwpp:068
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    1. Frank Smets & Raf Wouters, 2002. "An estimated dynamic stochastic general equilibrium model of the euro area," Working Paper Research 35, National Bank of Belgium.
    2. Preston, Bruce, 2005. "Learning about Monetary Policy Rules when Long-Horizon Expectations Matter," MPRA Paper 830, University Library of Munich, Germany.
    3. Saroj Bhattarai & Jae Won Lee & Woong Yong Park, 2012. "Inflation dynamics: the role of public debt and policy regimes," Globalization and Monetary Policy Institute Working Paper 124, Federal Reserve Bank of Dallas.
    4. Guido Ascari & Tiziano Ropele, 2007. "Optimal monetary policy under low trend inflation," Temi di discussione (Economic working papers) 647, Bank of Italy, Economic Research and International Relations Area.
    5. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Working Paper Series WP-01-08, Federal Reserve Bank of Chicago.
    6. Davig, Troy & Leeper, Eric M., 2009. "Monetary-Fiscal Policy Interactions and Fiscal Stimulus," CEPR Discussion Papers 7509, C.E.P.R. Discussion Papers.
    7. James Bullard & Kaushik Mitra, 2002. "Learning about monetary policy rules," Working Papers 2000-001, Federal Reserve Bank of St. Louis.
    8. Olivier J. Blanchard & Giovanni Dell'Ariccia & Paolo Mauro, 2010. "Rethinking Macroeconomic Policy," IMF Staff Position Notes 2010/03, International Monetary Fund.
    9. Francesco Bianchi, 2012. "Evolving Monetary/Fiscal Policy Mix in the United States," American Economic Review, American Economic Association, vol. 102(3), pages 167-72, May.
    10. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 129-147, February.
    11. WILLIAM A. BRANCH & TROY DAVIG & BRUCE McGOUGH, 2008. "Monetary-Fiscal Policy Interactions under Implementable Monetary Policy Rules," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(5), pages 1095-1102, 08.
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