How Inflationary is an Extended Period of Low Interest Rates?

20 Pages Posted: 9 Apr 2012

See all articles by Charles T. Carlstrom

Charles T. Carlstrom

Federal Reserve Bank of Cleveland

Timothy S. Fuerst

University of Notre Dame

Matthias Paustian

Bank of England

Date Written: January 12, 2012

Abstract

Recent monetary policy experience suggests a simple test of models of monetary non-neutrality. Suppose the central bank pegs the nominal interest rate below steady state for a reasonably short period of time. Familiar intuition suggests that this should be inflationary. But a monetary model should be rejected if a reasonably short nominal rate peg results in an unreasonably large inflation response. We pursue this simple test in three variants of the familiar dynamic new Keynesian (DNK) model. All of these models fail this test. Further some variants of the model produce inflation reversals where an interest rate peg leads to sharp deflations.

Suggested Citation

Carlstrom, Charles T. and Fuerst, Timothy S. and Paustian, Matthias, How Inflationary is an Extended Period of Low Interest Rates? (January 12, 2012). FRB of Cleveland Working Paper No. 12-02. Available at SSRN: https://ssrn.com/abstract=1984135

Charles T. Carlstrom (Contact Author)

Federal Reserve Bank of Cleveland ( email )

PO Box 6387
Cleveland, OH 44101-1387
United States
216-579-2294 (Phone)
216-579-3050 (Fax)

Timothy S. Fuerst

University of Notre Dame ( email )

Notre Dame, IN 46556
United States

Matthias Paustian

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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