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Is Forward-Looking Inflation Targeting Destabilizing? The Role of Policy's Response to Current Output under Endogenous Investment

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  • Kevin X.D. Huang

    () (Department of Economics, Vanderbilt University)

  • Qinglai Meng

    () (Department of Economics, Chinese University of Hong Kong)

Abstract

In sticky price models with endogenous investment, virtually all monetary policy rules that set a nominal interest rate in response solely to future inflation induce real indeterminacy of equilibrium. Applying the Samuelson-Farebrother conditions, we obtain a necessary and sufficient condition for local real determinacy, which reveals that increasing price stickiness or letting policy respond also to current output may help ensure a unique equilibrium. We find that the first channel by itself has a quantitatively negligible effect and almost all strict inflation-targeting rules lead to indeterminacy, whether with higher price stickiness or overall stickiness by incorporating firm-specific capital, sticky wages, or both. The effect of the second avenue depends on labor supply elasticity and stickiness. With high labor supply elasticity and price stickiness, indeterminacy is much less likely to occur as policy also responds to output. With estimated labor supply elasticity or empirically reasonable price stickiness, policy's response to output helps little in ensuring determinacy; even incorporating firm-specific capital makes only a marginal improvement. Incorporating sticky wages, on the other hand, greatly enhances the role of policy's response to output in ensuring determinacy. With both sticky wages and firm-specific capital incorporated, even a tiny response of policy to current output can render equilibrium determinate for a wide range of response of policy to future inflation.

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  • Kevin X.D. Huang & Qinglai Meng, 2007. "Is Forward-Looking Inflation Targeting Destabilizing? The Role of Policy's Response to Current Output under Endogenous Investment," Vanderbilt University Department of Economics Working Papers 0704, Vanderbilt University Department of Economics.
  • Handle: RePEc:van:wpaper:0704
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    Cited by:

    1. Arayssi, Mahmoud, 2014. "Nominal Income and Inflation Targeting," MPRA Paper 62066, University Library of Munich, Germany.
    2. Marco Airaudo & Edward F Buffie & Luis-Felipe Zanna, 2016. "Inflation Targeting and Exchange Rate Management In Less Developed Countries," IMF Working Papers 16/55, International Monetary Fund.
    3. McKnight, Stephen, 2017. "Are Consumption Taxes Preferable To Income Taxes For Preventing Macroeconomic Instability?," Macroeconomic Dynamics, Cambridge University Press, pages 1023-1058.
    4. Chen, Shu-Hua, 2015. "Macroeconomic (In)Stability Of Interest Rate Rules In A Model With Banking System And Reserve Markets," Macroeconomic Dynamics, Cambridge University Press, vol. 19(07), pages 1476-1508, October.
    5. Stephen McKnight, 2011. "Investment and interest rate policy in the open economy," Oxford Economic Papers, Oxford University Press, vol. 63(4), pages 673-699, December.
    6. Takushi Kurozumi & Willem Van Zandweghe, 2011. "Determinacy under Inflation Targeting Interest Rate Policy in a Sticky Price Model with Investment (and Labor Bargaining)," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 43(5), pages 1019-1033, August.
    7. Stephen McKnight, 2016. "Investment and forward-looking monetary policy: A Wicksellian solution to the problem of indeterminacy," Serie documentos de trabajo del Centro de Estudios Económicos 2016-02, El Colegio de México, Centro de Estudios Económicos.
    8. Vadim Khramov, 2012. "Assessing Dsge Models with Capital Accumulation and Indeterminacy," IMF Working Papers 12/83, International Monetary Fund.
    9. Buffie, Edward F., 2014. "The Taylor principle fights back, Part II," Journal of Economic Dynamics and Control, Elsevier, vol. 46(C), pages 30-49.
    10. Best, Gabriela, 2015. "A New Keynesian model with staggered price and wage setting under learning," Journal of Economic Dynamics and Control, Elsevier, vol. 57(C), pages 96-111.
    11. Buffie, Edward F., 2013. "The Taylor principle fights back, Part I," Journal of Economic Dynamics and Control, Elsevier, vol. 37(12), pages 2771-2795.
    12. Sveen, Tommy & Weinke, Lutz, 2013. "The Taylor principle in a medium-scale macroeconomic model," Journal of Economic Dynamics and Control, Elsevier, vol. 37(12), pages 3034-3043.

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    Keywords

    Forward-looking inflation targeting; current output; sticky prices; sticky wages; firm-specific capital; endogenous investment; indeterminacy; Samuelson-Farebrother conditions;

    JEL classification:

    • E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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