Policy Inertia and Equilibrium Determinacy in a New Keynesian Model with Investment

Carlstrom and Fuerst (2005) demonstrate that when investment is added to a new Keynesian model, forward-looking interest rate rules almost always lead to equilibrium indeterminacy, even when the central bank responds strongly to expected in‡ation. In this paper, we show that equilibrium determinacy can be retained with forward-looking rules, as long as there is policy inertia. Strong response to expected in‡ation is still essential in guaranteeing macroeconomic stability. Keywords: nominal rigidities, determinacy, interest rate rules, Taylor principle JEL Classi…cations: E32, E43, E52 Wei Xiao, Department of Economics, SUNY at Binghamton, P.O. Box 6000, Binghamton, NY 13902 USA. E–mail: [email protected] 1 Introduction Recently there have been considerable amount of research interests in designing interest rate rules to ensure equilibrium determinacy in a general equilibrium model with nominal rigidities. A classic result is that to avoid real indeterminacy central banks should respond strongly (more than one-for-one) to either expected or current in‡ation (Bernanke and Woodford, 1997; Clarida et al., 2000; Bullard and Mitra, 2002). This is often referred to as the Taylor principle. In these models investment is usually deemed nonessential. In their latest contribution, however, Carlstrom and Fuerst (2005) point out that investment can be crucial in evaluating interest rate rules. If investment is added to a new Keynesian model, the Taylor principle no longer guarantees equilibrium determinacy: forward-looking rules almost always lead to real indeterminacy, even when the central bank responds strongly to expected in‡ation. Current-looking rules, on the other hand, still relies on the Taylor principle to ensure determinacy. Since indeterminacy can cause excessive volatility, Carlstrom and Fuerst deliver a warning for policy conduct “there is clear danger to any policy that is forward-looking,”as they forcefully put. Their recipe is to favor current-looking rules, which leads to a determinate equilibrium as long as the policymakers react aggressively to current in‡ation. In reality, forward-looking behavior is quite common among central banks. Information about people’s in‡ation forecasts is regularly collected and analyzed,1 and is often used as a basis for formulating interest rate policies. Evidence of such policy conduct can be found not only among speeches and testimonies of central bankers, but also in empirical research of policy rules. For example, Clarida et al. (1998 and 2000) …nd that central banks in G7 countries have typically targeted anticipated in‡ation instead of lagged in‡ation since 1979. Orphanides (2001) reports 1For example, the Federal Reserve publishes a quarterly report of in‡ation forecasts from the Survey of Professional Forecasters. The European Central Bank, Bank of England, and several other central banks collect data from similar surveys. Many central banks also use prices of in‡ation-indexed government securities to infer about in‡ation expectations (Orphanides and Williams, 2005).