Inflation shocks and interest rate rules

Recent empirical evidence by Fair (2002, 2005) and Giordani (2003) shows that a positive inflation shock with the nominal interest rate held constant has contractionary effects. These results cannot be reconciled with the standard ‘New Synthesis’ literature. This paper reconsiders the effects of inflation shocks in a simple New Keynesian framework extended to include wealth effects. It is shown that, following an inflation shock, the decline of output coupled with passive interest rate rules is not puzzling. We are very grateful to Jean-Pascal Bénassy for his helpful comments and suggestions on a earlier version of this paper. Thanks are also due to Andrea Costa, Jordi Galí, Nicola Giammarioli, and Giancarlo Marini for useful comments and discussions. Financial support from CNR and the FIRB project is gratefully acknowledged. The usual disclaimer applies. A detailed Technical Appendix to the paper is available from the authors upon request. Citation: Annicchiarico, Barbara and Alessandro Piergallini, (2006) "Inflation shocks and interest rate rules." Economics Bulletin, Vol. 5, No. 19 pp. 1-7 Submitted: August 25, 2006. Accepted: December 12, 2006. URL: http://economicsbulletin.vanderbilt.edu/2006/volume5/EB-06E50009A.pdf