Learning About Inflation Measures for Interest Rate Rules

IMF Working Papers, December 1, 2010

Source details

Authors: Luis-Felipe Zanna, Marco Airaudo
Date: December 1, 2010
Research type: IMF Working Paper (Working Paper No. 2010/296)
Core objective: Develop a DSGE model with heterogeneous nominal rigidities across two sectors to study equilibrium determinacy and stability under adaptive learning for interest rate rules that respond to inflation measures differing in their degree of price stickiness.
Key subject areas: Consumption, Inflation, Labor, Real interest rates, Sticky prices
Keywords: least squares, WP

Empirical premise: Goods are highly heterogeneous with respect to the degree of price rigidity.
Principal result: Interest rate rules that respond to headline inflation measures which assign a positive weight to the inflation of the sector with low price stickiness are more prone to generate macroeconomic instability than rules that respond exclusively to the inflation of the sector with high price stickiness.
Types of problematic equilibria identified:
- Non-learnable fundamental-driven equilibria.
- Learnable self-fulfilling expectations equilibria.
- Equilibria where fluctuations are unbounded.

The paper discusses how results vary with:
- The elasticity of substitution across goods.
- The degree of heterogeneity in price rigidity.
- The timing of the interest-rate rule.

Framework: DSGE model with two sectors differing in nominal price rigidity.
Expectations formation: Adaptive learning.
Policy focus: Interest rate rules that respond to different inflation aggregates (headline measures that mix sectors versus sector-specific inflation measures).