The Eventual Failure and Price Indeterminacy of Inflation Targeting

Eagle, David (2006): The Eventual Failure and Price Indeterminacy of Inflation Targeting.

Abstract

In stark contrast to the previous literature, we find that IT leads to price indeterminacy even when the central bank uses a Taylor-like feedback rule to peg the nominal interest rate. We also find that there is no mechanism with IT to determine the current inflation rate or price level. We conclude that the previous literature has either committed mathematical errors involving infinity or misused the non-explosive criterion for ruling out speculative bubbles. To avoid making errors involving infinity, we analyze inflation targeting (IT) in a typical rational-expectations, pure-exchange, general-equilibrium model where the time horizon is arbitrarily large, but finite.

• Item Type: MPRA Paper
• Institution: Eastern Washington University
• Language: English
• Keywords: inflation targeting; price determinacy; monetary policy; pegging interest rates; errors of infinity
• Subjects: E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E42 - Monetary Systems ; Standards ; Regimes ; Government and the Monetary System ; Payment Systems; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E52 - Monetary Policy; E - Macroeconomics and Monetary Economics > E5 - Monetary Policy, Central Banking, and the Supply of Money and Credit > E58 - Central Banks and Their Policies

References

Altug, Sumru & Pamela Labadie (1994). Dynamic Choice and Asset Markets (Academic Press).

Blanchard, Olivier J. & Charles M. Kahn (1980), “The Solution of Linear Difference Models under Rational Expectations,” Econometrica, 48(#5):1305-1312.

Calin, Ovidue, Yu Chen, Thomas Cosimano, and Alex Himonas, (2005), “Solving Asset Pricing Models when the Price-Dividend Function is Analytic,” Econometrica 73(#3):961-982.

Carlstrom, Charles T. & Fuerst, Timothy S. (2001). "Timing and real indeterminacy in monetary models," Journal of Monetary Economics. 47(#2):285-298.

Clegg, Brian (2003), A Brief History of infinity: the Quest to Think the Unthinkable (Carroll & Graf – New York)

Dittmar, Robert D. and William T. Gavin (2005), “Inflation-Targeting, Price-Path Targeting and Indeterminacy,” Economic Letters 88:336-342.

Eagle, David (2005a). "Price Indeterminacy Reinvented: Pegging Interest Rates While Targeting Prices, Inflation, or Nominal Income," Macroeconomics 0501028, EconWPA database, http://ideas.repec.org/p/wpa/wuwpma/0501028.html, accessed on November 16, 2006.

__________ (2005b). "The Inflation Dynamics of Pegging Interest Rates," Macroeconomics 0502029, EconWPA database, http://ideas.repec.org/p/wpa/wuwpma/0502029.html, accessed on November 16, 2006.

__________ (2005c). "Multiple Critiques of Woodford’s Model of a Cashless Economy," Macroeconomics 0504028, EconWPA database, http://ideas.repec.org/p/wpa/wuwpma/0504028.html, accessed on November 16, 2006.

__________ (2006). "Revealing the Naked Truth about Price Determinacy and Infinite-Horizon Rational Expectations," Working Paper, http://www.cbpa.ewu.edu/~deagle/banking/NonExplosive.doc, accessed on November 22, 2006.

Eagle, David & Dale Domian, 2005. "Sounding the Alarm on Inflation Indexing and Strict Inflation Targeting," working paper, http://www.cbpa.ewu.edu/~deagle/banking/SOundingWEApaper.pdf, accessed on November 16, 2006.

Eagle, David & Elizabeth Murff, 2005. "Logical Pitfalls of Assuming Bounded Solutions to Expectational Difference Equations," GE, Growth, Math methods 0501002, EconWPA database, , accessed on November 16, 2006.

Lucas, Robert E. (1976). “Econometric Policy Evaluation: A Critique,” Carnegie-Rochester Conference Series on Public Policy 1, 19-46.

Lucas, Robert (1978), “Asset Prices in an Exchange Economy,” Econometrica 46(#6):1429-1445.

McCallum, Bennett T. (1981). “Price Level Determinacy with an Inteerst Rate Policy Rule and Rational Expectations,” Journal of Monetary Economics 8:319-329.

McCallum, Bennett (1999). “Role of the Minimal State Variable Criterion in Rational Expectations Models,” International Tax and Public Finance, 6:621–639.

Sargent, Thomas J. (1979). Macroeconomic Theory – Economic Theory, Econometrics, and Mathematical Economics (Academic Press – New York).

Sargent, Thomas J. and Neil Wallace (1975). “‘Rational’ Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule,” Journal of Political Economy 83:241-254.

Woodford, Michael (2003). Interest and Prices – A Foundation of a Theory of Monetary Policy (Princeton University of Press – Princeton, New Jersey).