Is Moderate-to-High Inflation Inherently Unstable?
33 Pages Posted: 20 Dec 2004
Date Written: July 2004
The data across time and countries suggest the level and variance of inflation are highly correlated. This paper examines the effect of trend inflation on the ability of the monetary authority to ensure a determinate equilibrium and macroeconomic stability in a sticky-price model. Trend inflation increases the importance of future marginal costs for current price-setters in a staggered price-setting model. The greater importance of expectations makes it more difficult for the monetary authority to ensure stability; in fact, equilibrium determinacy cannot be achieved through reasonable specifications of nominal interest rate (Taylor) rules at moderate-to-high levels of inflation (for example, at levels around 4 percent per year). If monetary policymakers have followed these types of policy rules in the past, this result may explain why moderate-to-high inflation is associated with inflation volatility. It also suggests a revision to interpretations of the 1970s. At that time, inflation in many countries was at least moderate, which can contribute to economic instability. The results suggest that some moderate-inflation countries that have recently adopted inflation targeting may want to commit to low target inflation rates.
Keywords: Monetary policy, equilibrium determinacy, Taylor rule, sunspot fluctuations
JEL Classification: E3, E5
Suggested Citation: Suggested Citation