Inflation, Real Interest, and the Determinacy of Equilibrium in an Optimizing Framework

23 Pages Posted: 18 Aug 2004 Last revised: 25 Jun 2010

See all articles by Maurice Obstfeld

Maurice Obstfeld

University of California, Berkeley - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Date Written: July 1981

Abstract

This paper examines the short-run relation between anticipated inflation and the real rate of interest in a model where agents with perfect foresight maximize utility over infinite lifetimes. In addition to deriving behavioral functions from explicit intertemporal optimization, the approach taken here departs from the usual IS-LM analysis in that it is dynamic and deals with a small economy open to trade in consumption goods. Because capital mobility must be ruled out to allow scope for variation in the real interest rate, the results obtained here for one of the two exchange- rate regimes considered -- free floating -- apply equally to a closed economy. The paper shows that an increase in the expected inflation rate depresses the real interest rate in the short run when the exchange rate is instantaneously fixed by the central bank. When equilibrium is determinate in the floating-rate case, the real interest rate is invariant with respect to inflation.

Suggested Citation

Obstfeld, Maurice, Inflation, Real Interest, and the Determinacy of Equilibrium in an Optimizing Framework (July 1981). NBER Working Paper No. w0723. Available at SSRN: https://ssrn.com/abstract=349116

Maurice Obstfeld (Contact Author)

University of California, Berkeley - Department of Economics ( email )

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HOME PAGE: http://emlab.berkeley.edu/users/obstfeld/

Centre for Economic Policy Research (CEPR)

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National Bureau of Economic Research (NBER)

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