Controlling Inflation With Interest Rate Rules in Models with Sticky Prices

This paper examines the properties of interest rate rules aimed at controlling aggregate price inflation. Policies are compared in two models having either flexible or sticky inflation The latter is assumed to derive from a traditional, adaptive-expectations augmented Phillips curve. The flexible inflation model derives from the modem view, due to Gray (1976) and Fischer (1977), that market clearing failure in labor markets arises from imperfectly indexed wage contracts with finite durations. Extensions positing the existence of overlapping contracts were advanced by Phelps and Taylor( 1977) and Calvo (1983). The main problem facing economies with sticky inflation is instability, whereas the principal concern in forward-looking models with flexible inflation is price level and inflation indeterminacy. Therefore, policies that succeed in one kind of economy may not work in another. Nominal anchors, like money and nominal GNP fail to stabilize prices, unless there is additional interest rate smoothing. In the flexible inflation regime, interest rate smoothing is superfluous, and unique and stable price paths are obtainable with interest rate reaction functions that target nominal GNP, money, and nominal asset prices. In an economy characterized by flexible inflation, a rule for commodity prices proposed by Federal Reserve Board Governor Wayne D. Angell is shown to be independent of potentially unknown model parameters. Although the channels of policy become less direct, as in the case of money targeting, an offsetting advantage is derived from the fact that policy is completely determined by observations of readily available spot prices. It is also shown that in a staggered wage setting model, disinflation is accompanied by increases in output, a conclusion that has questionable plausibility