by Michael T. Kiley
Federal Reserve Board
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 inflation 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 two senses. First, equilibrium determinacy is more difficult to achieve through reasonable specifications of nominal-interest-rate (Taylor) rules at moderate-to-high levels of inflation (e.g., at levels around 4 percent per year). In addition, the volatility of inflation induced by cost-push shocks is, all else equal, higher at higher rates of inflation under a reasonable specification of the nominal-interest-rate rule. If monetary policymakers have followed these types of policy rules in the past, these results may explain, in part, why moderate-to-high inflation is associated with inflation volatility.
JEL Codes: E3, E5.
Full article (PDF, 29 pages 390 kb)