Sluggish Inflation Expectations: A Markov Chain Analysis

Narayana Kocherlakota

No 22009, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: A large body of recent empirical work on inflation dynamics documents that current real variables (like unemployment or output gaps) have little explanatory power for future inflation. Motivated by these findings, I explore the properties of a wide class of models in which inflation expectations respond little, if at all, to real economic conditions. In this general context, I examine Markov equilibria to games in which the relevant forcing processes are Markov chains and the central bank chooses a short- term nominal interest rate at each date subject to a lower bound. I construct a simple numerical algorithm to solve for such Markov equilibria. I apply the algorithm to a numerical example. In the example, the economy can experience long periods of what looks like secular stagnation because households believe that there is a significant risk of a crisis (that is, a sharp decline in economic activity). Within the example, there are large benefits to being able to reduce the lower bound on the short-term nominal interest rate by as little as fifty basis points.

JEL-codes: E31 E32 E52 E58 (search for similar items in EconPapers)
Date: 2016-02
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
Note: EFG ME
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Citations: View citations in EconPapers (7)

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