The New Consensus in Monetary Policy: Is the NKM fit for the purpose of inflation targeting?

In this paper we examine whether or not the NKM is .t for the purpose of providing a suitable basis for the conduct of monetary policy through inflation targeting. We focus on a number of issues: the dynamic response of inflation to interest rates in a theoretical NKM under discretion and commitment to a Taylor rule; the implications for the specification of the New Keynesian Phillips equation of alternative models of imperfect competition in a closed and an open economy; the general equilibrium underpinnings of the IS function; the extent of empirical support for the NKM; what the empirical evidence on the NKM implies for inflation targeting. Our findings reveal a number of problems with the NKM. Theoretically, the NKM predicts that a discretionary increase in interest rates will increase inflation, not reduce it. This is supported by our VAR evidence. Estimates of the NKM indicate a negative relation between interest rates and inflation, but the signs in the structural equations are inconsistent with the theory. We conclude that the standard specifications of the inflation and output equations are inadequate and that these equations should be embedded in a larger model.