Inflation Forecast-Based-Rules and Indeterminacy: A Puzzle and a Resolution

36 Pages Posted: 30 Jun 2006

See all articles by Paul Levine

Paul Levine

School of Economics, University of Surrey

Peter McAdam

European Central Bank (ECB); University of Surrey, Economics

Joseph Pearlman

London Metropolitan University - Department of Economics, Finance and International Business (EFIB)

Date Written: June 2006

Abstract

We examine an interesting puzzle in monetary economics between what monetary authorities claim (namely to be forward-looking and pre-emptive) and the poor stabilization properties routinely reported for forecast-based rules. Our resolution is that central banks should be viewed as following Calvo-type inflation-forecast-based (IFB) interest rate rules which depend on a discounted sum of current and future rates of inflation. Such rules might be regarded as both within the legal frameworks, and potentially mimicking central bankers' practice. We find that Calvo-type IFB interest rate rules are first: less prone to indeterminacy than standard rules with a finite forward horizon. Second, for such rules in difference form, the indeterminacy problem disappears altogether. Third, optimized forms have good stabilization properties as they become more forward-looking, a property that sharply contrasts that of standard IFB rules. Fourth, they appear data coherent when incorporated into a well-known estimated DSGE model of the Euro-area.

Keywords: Inflation-forecast-based interest rate rules, Calvo-type interest rate rules

JEL Classification: E52, E37, E58

Suggested Citation

Levine, Paul L. and McAdam, Peter and Pearlman, Joseph G., Inflation Forecast-Based-Rules and Indeterminacy: A Puzzle and a Resolution (June 2006). ECB Working Paper No. 643. Available at SSRN: https://ssrn.com/abstract=907311

Paul L. Levine (Contact Author)

School of Economics, University of Surrey ( email )

Guildford
Surrey GU2 7XH
United Kingdom
+44 1483 259 380 Ext. 2773 (Phone)
+44 1483 259 548 (Fax)

Peter McAdam

European Central Bank (ECB) ( email )

Kaiserstrasse 29
Eurotower
D-60311 Frankfurt am Main
Germany
0049 69 13440 (Phone)
0044 69 1344 6000 (Fax)

University of Surrey, Economics ( email )

Guildford
Guildford, Surrey GU2 5XH
United Kingdom

Joseph G. Pearlman

London Metropolitan University - Department of Economics, Finance and International Business (EFIB) ( email )

Economics Subject Group, LMBS
London EC2M 6SQ, EC2M 6SQ
United Kingdom

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