Are Low Interest Rates Deflationary? A Paradox of Perfect-Foresight Analysis

Mariana García-Schmidt and Michael Woodford

Working Papers Central Bank of Chile from Central Bank of Chile

Abstract: A prolonged period of extremely low nominal interest rates has not resulted in high inflation. This has led to increased interest in the “Neo-Fisherian" proposition according to which low nominal interest rates may themselves cause inflation to be lower. The fact that standard models have the property that perfect foresight equilibria with a low fixed interest rate forever involve low inflation might seem to support such a view. Here, however, we argue that such a conclusion depends on a misunderstanding of the circumstances under which it makes sense to predict the effects of a monetary policy commitment by calculating the perfect foresight equilibrium (PFE). We propose an explicit cognitive process by which agents form their expectations of future endogenous variables. Under some circumstances, such as a commitment to follow a Taylor rule, a PFE can arise as a limiting case of our more general concept of reflective equilibrium. But we show that a policy of fixing the interest rate for a long period of time creates a situation in which reflective equilibrium need not resemble any PFE. In our view, this makes PFE predictions not plausible outcomes in the case of policies of the latter sort. According to our alternative approach, a commitment to maintain a low nominal interest rate for longer should always be expansionary and inflationary; but likely less so than the usual PFE analysis would imply, and much less in the case of a long-horizon commitment.

Date: 2016-12
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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Citations: View citations in EconPapers (3)

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Journal Article: Are Low Interest Rates Deflationary? A Paradox of Perfect-Foresight Analysis (2019)
Working Paper: Are Low Interest Rates Deflationary? A Paradox of Perfect-Foresight Analysis (2015)
Working Paper: Are Low Interest Rates Deflationary? A Paradox of Perfect-Foresight Analysis (2015)
Working Paper: Are Low Interest Rates Deflationary? A Paradox of Perfect-Foresight Analysis (2015)
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