Inflation Determination With Taylor Rules: A Critical Review

Abstract

The new-Keynesian, Taylor-rule theory of inflation determination relies on explosive dynamics. By raising interest rates in response to inflation, the Fed does not directly stabilize future inflation. Rather, the Fed threatens hyperinflation or deflation, unless inflation jumps to one particular value on each date. However, there is nothing in economics to rule out hyperinflationary or deflationary solutions. Therefore, inflation is just as indeterminate under "active" interest rate targets as it is under standard fixed interest rate targets. Inflation determination requires ingredients beyond an interest-rate policy that follows the Taylor principle.

Keywords: Taylor rule, determinacy, interest rate, inflation, price level

JEL Classification: E31, E42, E52