IS MODERATE-TO-HIGH INFLATION INHERENTLY UNSTABLE?

Abstract

The data across time and countries suggest that moderate-to-high inflation and inflation volatility are highly correlated. This paper examines the effect of trend inflation on the ability of the monetary authority to ensure a determinate equilibrium and macroeconomic 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 fact, equilibrium determinacy cannot be achieved through reasonable specifications of nominal interest rate (Taylor) rules at moderate-to-high levels of inflation (for example, at levels below 8 percent per year). If monetary policymakers have followed these types of policy rules in the past, this result may explain why moderate-to-high inflation is associated with inflation volatility. It also suggests a revision to interpretations of the 1970s. At that time, inflation in many countries was at least moderate, which can contribute to economic instability. The results suggest that some moderate-inflation countries that have recently adopted inflation targeting may want to commit to low target inflation ratesMonetary policy; equilibrium determinacy; Taylor rule; sunspot fluctuations