December 2007 issue contents
Inflation-Forecast-Based Rules and Indeterminancy: A Puzzle and a Resolution

by Paul Levinea, Peter McAdamb and Joseph Pearlmanc


We examine an interesting puzzle in monetary economics between what monetary authorities claim (namely, to be forward looking and preemptive) and the poor stabilization properties routinely reported for forecast-based rules. Our resolution is that central banks should be viewed as following "Calvo-type" inflation-forecast-based (IFB) interest rate rules that depend on a discounted sum of current and future rates of inflation. Such rules might be regarded as both within the legal frameworks and potentially mimicking central bankers' practice. We find that Calvo-type IFB interest rate rules are, first, less prone to indeterminacy than standard rules with a finite forward horizon. Second, in difference form, the indeterminacy problem disappears altogether. Third, optimized forms have good stabilization properties as they become more forward looking, a property that sharply contrasts that of standard IFB rules. Fourth, they appear data coherent when incorporated into a well-known estimated dynamic stochastic general equilibrium (DSGE) model of the euro area.

JEL Codes: E52, E37, E58.

Full article (PDF, 34 pages 481 kb)

a University of Surrey
b European Central Bank
c London Metropolitan University