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Beyond the Taylor rule. A New-Keynesian model to understand inflation and central bank policies

Stefano Fugazzi (ABC Economics) – Hereafter we present the main conclusions of a Bank of England research paper published on 10 July 2015 by John Barrdear (“Towards a New Keynesian theory of the price level”) where the author challenges the Taylor rule (also known as Taylor principle) under the Blanchard-Kahn conditions.

A critique of the Taylor principle and the Blanchard-Kahn conditions

In economics, the Taylor principle is a monetary-policy rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions. In particular, the rule stipulates that for each one-percent increase in inflation, the central bank should raise the nominal interest rate by more than one percentage point.

The language used to explain (and justify) the Taylor principle is quite simple. By raising the nominal interest rate by more than one-for-one in response to an increase in inflation, the monetary authority ensures that the real interest rate rises. This subdues economic activity among interest sensitive agents, which in turn dampens the rate of price inflation. In 2011 J. H. Cochrane described this logic as being “Old Keynesian” and emphasised that it is directly at odds with the mathematics of “New Keynesian” models that, via Blanchard-Kahn, rely on inducing explosive dynamics in order to achieve determinacy.

Beyond the Taylor principle. Understanding inflation and central bank policies under business as usual (“steady-state”) and stressed market conditions (“out of steady-state”)

According to John Barrdear of Bank of England, in a model with dispersed information and flexible prices, satisfying the Taylor principle produces a form of instability that cannot be addressed with a no-bubble constraint. This is because with dispersed information, stability in the current price level requires not only stability in expected future prices, but also stability in the current hierarchy of expectations (a requirement that is sidestepped under full information). As the coefficient against inflation in the monetary authority’s decision rule rises towards one, the equilibrium strategic complementarity between firms increases, leading eventually to prices becoming explosive in higher-order beliefs.

The Bank of England researcher proposes a variation of the New-Keynesian model for which: in steady-state the rate of inflation is uniquely determined as a choice of the monetary authority, while out of steady-state (that is, when the model is subject to shocks) – and conditional on no change in steady-state – not just the rate of inflation but also the deviation of the price level is determinate, despite the monetary authority being an inflation-targeter.

In other words, within steady-state, the final assumption grants that the steady-state rate of inflation is uniquely pinned down as a choice of the monetary authority. Out of steady-state (that is, when the model is subject to shocks), the combination of flexible prices and a central bank that responds only to expected future inflation removes all mention of previous-period prices when producing current-period decisions. Together with incomplete information, under which all expectations (including of future variables) become combinations of current and past observables, the current-period price level becomes a function of only firms’ expectations regarding the hidden state of the economy, and their beliefs about the beliefs of other firms. The price level of the economy is therefore determined, up to an initial value.

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