Inflation, Nominal Interest Rates, and the Variability of Output

IMF Working Papers, October 1, 1996

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Canonical URL: Inflation, Nominal Interest Rates, and the Variability of Output

This paper examines the distribution of output around capacity when money demand is a nonlinear function of the nominal interest rate such that nominal interest rates cannot become negative.
Key comparative-statics findings:
- When fluctuations in output result primarily from disturbances to the money market, the variance of output is an increasing function of the trend inflation rate.
- When fluctuations in output result primarily from disturbances to the goods market, the variance of output is a decreasing function of the trend inflation rate.
- When both disturbances are significant, there exists, in general, a critical non-zero trend inflation rate that minimizes the variance of output.

Money demand specification:
- Money demand is modeled as a nonlinear function of the nominal interest rate, with the property that nominal interest rates cannot become negative.
Channels emphasized:
- Money-market disturbances: amplify output variance as trend inflation rises.
- Goods-market disturbances: reduce output variance as trend inflation rises.
- Interaction of both disturbance types: generates a non-monotonic relationship between trend inflation and output variance, implying an interior optimal trend inflation rate that minimizes output variability.

Subject: Capacity utilization, Demand for money, Financial services, Inflation, Monetary base, Money, Prices, Production, Real interest rates
Keywords: Capacity utilization, Demand for money, Inflation, inflation rate rise, long-run inflation rate influence, Monetary base, money demand function, nominal interest rate, price level, rate of inflation, Real interest rates, shock term, trend inflation rate, WP