Endogenous Inflation and the Taylor Rule

Abstract

I explore the term structure of interest rates, inflation expectations, and inflation risk premia in an endogenous inflation economy. I illustrate the implications of such an economy in a macro-finance model in which the Taylor rule shock and consumption growth have Markov-switching dynamics. A calibrated version of the model generates a nearly flat term structure of inflation expectations and an upward-sloping term structure of inflation risk premia. I then use the model to conduct monetary policy experiments and measure the effects of monetary policy changes on the dynamics of nominal quantities in the economy. I find that varying the monetary policy parameters in the Taylor rule has a large effect on both inflation expectations and inflation risk premia. A modified version of the model can capture the zero bound constraint on the short-term interest rate.

Keywords: term structure, monetary policy, break-even inflation, inflation expectations, inflation risk premia, zero bound

JEL Classification: E43, E52, G12