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

Mariana García-Schmidt and Michael Woodford

No 21614, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: We illustrate a pitfall that can result from the common practice of assessing alternative monetary policies purely by considering the perfect foresight equilibria (PFE) consistent with the proposed rule. In a standard New Keynesian model, such analysis may seem to support the “Neo-Fisherian” proposition according to which low nominal interest rates can cause inflation to be lower. We propose instead an explicit cognitive process by which agents may form their expectations of future endogenous variables. Under some circumstances, a PFE can arise as a limiting case of our more general concept of reflective equilibrium, when the process of reflection is pursued sufficiently far. But we show that an announced intention to fix the nominal interest rate for a long enough 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 such policies. Our alternative approach implies that a commitment to keep interest rates low should raise inflation and output, though by less than some PFE analyses apply.

JEL-codes: E31 E43 E52 (search for similar items in EconPapers)
Date: 2015-10
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
Note: EFG ME
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Citations: View citations in EconPapers (80)

Published as Mariana García-Schmidt & Michael Woodford, 2019. "Are Low Interest Rates Deflationary? A Paradox of Perfect-Foresight Analysis," American Economic Review, vol 109(1), pages 86-120.

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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 (2016)
Working Paper: Are Low Interest Rates Deflationary? A Paradox of Perfect-Foresight Analysis (2015)
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