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Are Low Interest Rates Deflationary? A Paradox of Perfect- Foresight Analysis

Author

Listed:
  • Mariana Garcia-Schmidt

    (Columbia University)

  • Michael Woodford

    () (Columbia University)

Abstract

A prolonged period of extremely low nominal interest rates has not resulted in high inflation. This has led to increased interest in the `Neo-Fisherian` proposition according to which low nominal interest rates may themselves cause inflation to be lower. The fact that standard models of the effects of monetary policy have the property that perfect foresight equilibria in which the nominal interest rate remains low forever necessarily involve low inflation (at least eventually) might seem to support such a view. Here, however, we argue that such a conclusion depends on a misunderstanding of the circumstances under which it makes sense to predict the effects of a monetary policy commitment by calculating the perfect foresight equilibrium consistent with the policy. We propose an explicit cognitive process by which agents may form their expectations of future endogenous variables. Under some circumstances, such as a commitment to follow a Taylor rule, a perfect foresight equilibrium (PFE) can arise as a limiting case of our more general concept of reflective equilibrium, when the process of reflection is pursued sufficiently far. But we show that an announced intention to fix the nominal interest rate for a long enough period of time creates a situation in which reflective equilibrium need not resemble any PFE. In our view, this makes PFE predictions not plausible outcomes in the case of policies of the latter sort. According to the alternative approach that we recommend, a commitment to maintain a low nominal interest rate for longer should always be expansionary and inflationary, rather than causing deflation; but the effects of such `forward guidance` are likely, in the case of a long horizon commitment, to be much less expansionary or inflationary than the usual PFE analysis would imply.

Suggested Citation

  • Mariana Garcia-Schmidt & Michael Woodford, 2015. "Are Low Interest Rates Deflationary? A Paradox of Perfect- Foresight Analysis," Working Papers Series 18, Institute for New Economic Thinking.
  • Handle: RePEc:thk:wpaper:18
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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