Determinacy and Identification with Taylor Rules

Abstract

The new-Keynesian, Taylor-rule theory of inflation determination relies on explosive dynamics. By raising interest rates in response to inflation, the Fed induces ever-larger inflation or deflation, unless inflation jumps to one particular value on each date. However, economics does not rule out inflationary or deflationary equilibria. Attempts to fix this problem assume that people believe the government will choose to blow up the economy if alternative equilibria emerge, by following policies we usually consider impossible. Therefore, inflation is just as indeterminate under “active” interest rate targets as it is under fixed interest rate targets. If one accepts the new-Keynesian solution, the parameters of the Taylor rule relating interest rates to inflation and other variables are not identified without unrealistic assumptions. Thus, Taylor rule regressions cannot be used to argue that the Fed conquered inflation by moving from a “passive” to an “active” policy in the early 1980s. The updated version presented here merges the content of two companion papers, w13409 and w13410, into a single current version. Thus, as of September 2010, w13409 and w13410 are identical.