Why Money Growth Determines Inflation in the Long Run: Answering the Woodford Critique

Woodford argues that it is not appropriate to regard inflation in the steady state of New Keynesian models as determined by steady‐state money growth. Woodford instead argues that the intercept term in the monetary authority's interest rate policy rule determines steady‐state inflation. In this paper, I offer an alternative interpretation of steady‐state behavior, according to which it is appropriate to regard steady‐state inflation as determined by steady‐state money growth. The argument relies on traditional interpretations of the central bank's power in the long run and appeals to model properties that are common to textbook and New Keynesian analysis. According to this argument, the only way the central bank can control interest rates in the long run is via affecting inflation, and its only means available for determining inflation is by determining the money growth rate.     

Fiscal Activism and the Zero Nominal Interest Rate Bound

In an economy where the zero lower bound on nominal interest rates is an occasionally binding constraint and the government lacks a commitment technology, it may be desirable for society to appoint a policymaker who cares less about government spending stabilization relative to inflation and output gap stabilization than the private sector does. A policymaker of this type uses government spending more elastically to stabilize the economy. At the zero lower bound, the anticipation of aggressive fiscal expansions in future liquidity trap situations increases inflation expectations and lowers real interest rates, thereby mitigating the decline in output and inflation.     

Interest‐Rate Pegs in New Keynesian Models

The conventional policy perspective is that lowering the interest rate increases output and inflation in the short run, while maintaining inflation at a higher level requires a higher interest rate in the long run. In contrast, it has been argued that a Neo‐Fisherian policy of setting an interest‐rate peg at a fixed higher level will increase the inflation rate. We show that adaptive learning argues against the Neo‐Fisherian approach. Pegging the interest rate at a higher level will induce instability and most likely lead to falling inflation and output over time. Eventually, this would precipitate a change of policy.     

The Most Beautiful Variations on Fair Wages and the Phillips Curve

This paper explores the connection between inflation and unemployment in two different models with fair wages in both the short and the long runs. Under customary assumptions regarding the sign of the parameters of the effort function, more inflation lowers the unemployment rate, albeit to a declining extent. This is because firms respond to inflation—which spurs effort by decreasing the reference wage—by increasing employment, thus maintaining the effort level constant as implied by the Solow condition. A stronger short‐run effect of inflation on unemployment is produced under varying as opposed to fixed capital, given that in the former case the boom produced by a monetary expansion is reinforced by an increase in investment. Therefore, I provide a new theoretical foundation for recent empirical contributions that find negative long‐ and short‐run effects of inflation on unemployment.     

A New Model of Inflation,Trend Inflation,and Long‐Run Inflation Expectations

This paper develops a bivariate model of inflation and a survey‐based long‐run forecast of inflation that allows for the estimation of the link between trend inflation and the long‐run forecast. Thus, our model allows for the possibilities that long‐run forecasts taken from surveys can be equated with trend inflation, that the two are completely unrelated, or anything in between. Using a variety of inflation measures and survey‐based forecasts for several countries, we find that long‐run forecasts can provide substantial help in refining estimates and fitting and forecasting inflation. It is less helpful to simply equate trend inflation with the long‐run forecasts.     

Inflation Dynamics When Inflation Is Near Zero

We discuss the likely evolution of U.S. inflation in the near and medium terms on the basis of (i) past U.S. experience with very low levels of inflation, (ii) the most recent Japanese experience with negative inflation, and (iii) some preliminary U.S. micro evidence on downward nominal wage rigidity. Our findings question the view that stable long‐run inflation expectations and downward nominal wage rigidity will necessarily provide sufficient support to prices to avoid further declines in inflation. We show that an inflation model fitted on Japanese data over the past 20 years, which accounts for both short‐ and long‐run inflation expectations, matches the recent U.S. inflation experience quite well. While the model indicates that U.S. inflation might be subject to a lower bound, it does not rule out a prolonged period of low inflation or even mild deflation going forward. In addition, micro‐level data on wages suggest no obvious downward rigidity in the firm's wage bill, downward rigidity in individual wages notwithstanding. As a consequence, downward nominal wage rigidity may not be enough to offset deflationary pressures in the current situation.     

When Preferences for a Stable Interest Rate Become Self‐Defeating

Monetary policymakers often seem to have preferences for a stable interest rate, in addition to stable inflation and output. In this paper, we investigate the implications of having an interest rate level term in the loss function when the policymaker lacks commitment technology. We show that such preferences may become self‐defeating, in the sense that they generate a less stable interest rate than in the case without preferences for interest rate stability.     

Unstable Inflation Targets

This paper studies long‐run inflation targets and stability in an imperfect information environment. When central banks set an inflation target that is not fully communicated, agents draw inferences about inflation from recent data and remain alert to structural change by forming expectations from a forecasting model that is estimated via discounted least squares. Inflation targets can lead agents' beliefs to depart from rational expectations through two channels. First, implementing a higher inflation target can lead to overshooting. Second, there can be nearly self‐fulfilling inflation, disinflation, or deflation that arises as an endogenous response to shocks. Policy implications for implementing a higher target without deanchoring expectations are discussed.     

Adaptive learning, forecast-based instrument rules and monetary policy

This paper argues that recently popular forecast-based instrument rules for monetary policy may fail to stabilize economic fluctuations. In a New Keynesian model of output gap and inflation determination in which private agents face multi-period decision problems, but have non-rational expectations and learn over time, if the monetary authority adopts a forecast-based instrument rule and responds to observed private forecasts then this class of policies frequently induce divergent learning dynamics. A central bank that correctly understands private behavior can mitigate such instability by responding to the determinants of private forecasts. This suggests gathering information on the determinants of expectations to be useful.     

Downward Nominal Wage Rigidities Bend the Phillips Curve

We introduce a model of monetary policy with downward nominal wage rigidities and show that both the slope and curvature of the Phillips curve depend on the level of inflation and the extent of downward nominal wage rigidities. This is true for the both the long‐run and the short‐run Phillips curve. Comparing simulation results from the model with data on U.S. wage patterns, we show that downward nominal wage rigidities likely have played a role in shaping the dynamics of unemployment and wage growth during the last three recessions and subsequent recoveries.     

How to Weigh Unemployment Relative to Inflation in Monetary Policy?

The monetary policy mandate for the Federal Reserve and of the Riksbank are essentially the same and boil down to stabilizing inflation around the inflation target and employment or unemployment around a long‐run sustainable rate. The relative weight on stabilizing unemployment or employment versus stabilizing inflation may be close to one. A positive unemployment‐gap forecast normally calls for a positive inflation‐gap forecast.     

Monetary Policy with Heterogeneous and Misspecified Expectations

In the recent literature on monetary policy and learning, it has been suggested that private sector's expectations should play a role in the policy rule implemented by the central bank, as they could improve the ability of the policymaker to stabilize the economy. Private sector's expectations, in these studies, are often taken to be homogeneous and rational, at least in the limit of a learning process. In this paper, instead, we consider the case in which private agents are heterogeneous in their expectations formation mechanisms and hold heterogeneous expectations in equilibrium. We investigate the impact of this heterogeneity in expectations on central bank's policy implementation and on the ensuing economic outcomes, and the general result that emerges is that the central bank should disregard inaccurate private sector expectations and solely base its policy on the accurate ones.     

Rules,discretion and reputation in a model of monetary policy

In a discretionary regime the monetary authority can print more money and create more inflation than people expect. But, although these inflation surprises can have some benefits, they cannot arise systematically in equilibrium when people understand the policymaker's incentives and form their expectations accordingly. Because the policymaker has the power to create inflation shocks ex post, the equilibrium growth rates of money and prices turn out to be higher than otherwise. Therefore, enforced commitments (rules) for monetary behavior can improve matters. Given the repeated interaction between the policymaker and the private agents, it is possible that reputational forces can substitute for formal rules. Here, we develop an example of a reputational equilibrium where the outcomes turn out to be weighted averages of those from discretion and those from the ideal rule. In particular, the rates of inflation and monetary growth look more like those under discretion when the discount rate is high.     

Inflation Band Targeting and Optimal Inflation Contracts

In this paper we provide a theoretical treatment of how inflation target ranges cope with the time-inconsistency problem arising from incentives for the monetary policymaker to exploit the short-run trade-off between employment and inflation to pursue short-run employment objectives, as in a Barro-Gordon (1983) model. Inflation band targets are able to achieve many of the benefits that arise under practically less attractive solutions such as the conservative central banker and optimal inflation contracts. Our theoretical model also shows how an inflation targeting range should be set and how it should respond to changes in the nature of shocks to the economy.     

How Important Is Money in the Conduct of Monetary Policy?

I consider some of the leading arguments for assigning an important role to tracking the growth of monetary aggregates when making decisions about monetary policy. First, I consider whether ignoring money means returning to the conceptual framework that allowed the high inflation of the 1970s. Second, I consider whether models of inflation determination with no role for money are incomplete, or inconsistent with elementary economic principles. Third, I consider the implications for monetary policy strategy of the empirical evidence for a long‐run relationship between money growth and inflation. And fourth, I consider reasons why a monetary policy strategy based solely on short‐run inflation forecasts derived from a Phillips curve may not be a reliable way of controlling inflation. I argue that none of these considerations provides a compelling reason to assign a prominent role to monetary aggregates in the conduct of monetary policy.     

Managing Beliefs about Monetary Policy under Discretion

In models of monetary policy, discretionary policymaking is typically constrained in its ability to manage public beliefs. However, when a policymaker possesses private information, policy actions serve as signals to the public about unobserved economic conditions and belief management becomes an integral part of optimal discretion policies. This article derives the optimal time‐consistent policy for a general linear‐quadratic setting. The optimal policy is illustrated in a simple New Keynesian model, where analytical solutions can be derived as well. In this model, imperfect information about the policymaker's output target leads to lower policy losses.     

Raise Rates to Raise Inflation? Neo‐Fisherianism in the New Keynesian Model

Increasing the inflation target in a New Keynesian (NK) model may require increasing, rather than decreasing, the nominal interest rate in the short run. We refer to this positive short‐run comovement between the nominal rates and inflation conditional on a nominal shock as Neo‐Fisherianism. We show that the NK model is more likely to be Neo‐Fisherian the more persistent is the change in the inflation target and the more flexible are prices. Neo‐Fisherianism is driven by the forward‐looking nature of the model. Modifications that make the framework less forward‐looking make it less likely for the model to exhibit Neo‐Fisherianism.     

Inflation targeting and nominal-income-growth targeting: When and why are they suboptimal?

We compare optimal and simple interest-rate rules. Our model features optimizing agents, monopolistic competition in both product and labor markets, and one-period nominal contracts (for wages alone or for both wages and prices) signed before shocks are known. Exact solutions ensure that we obtain correct welfare rankings. Optimal rules maximize the unconditional expected utility of the representative agent with commitment subject to the information set of the policymaker. Even with monopolistic distortions, the optimal full-information rule makes the economy mimic the hypothetical full-flexibility equilibrium. Strict versions of inflation targeting, nominal-income-growth targeting, and other such simple rules are suboptimal under both full and partial information but flexible versions are optimal under certain partial-information assumptions. Nominal-income-growth targeting dominates inflation targeting for plausible parameter values.     

Heterogeneous Inflation Expectations and Learning

Using the panel component of the Michigan Survey of Consumers, we estimate a learning model of inflation expectations, allowing for heterogeneous use of private information and lifetime inflation experience. Life experience inflation has a significant impact on individual expectations, but only for 1‐year‐ahead inflation. Public information is substantially more relevant for longer horizon expectations. Even controlling for life experience inflation and public information, idiosyncratic information explains a nontrivial proportion of the inflation forecasts of agents. Women, ethnic minorities, and less educated agents have a higher degree of heterogeneity in their idiosyncratic information, and give less importance to recent movements in inflation.     

Uncertainty,Inflation, and Welfare

This paper studies the welfare costs and the redistributive effects of inflation in the presence of idiosyncratic liquidity risk, in a microfounded search‐theoretical monetary model. We calibrate the model to match the empirical aggregate money demand and the distribution of money holdings across households and study the effects of inflation under the implied degree of market incompleteness. We show that in the presence of imperfect insurance the estimated long‐run welfare costs of inflation are on average 40% to 55% smaller compared to a complete markets, representative agent economy, and that inflation induces important redistributive effects across households.