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

94 Pages Posted: 2 Oct 2015

See all articles by Michael Woodford

Michael Woodford

Columbia University, Graduate School of Arts and Sciences, Department of Economics

Mariana Garcia-Schmidt

Columbia University, Graduate School of Arts and Sciences, Department of Economics, Students

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Date Written: September 5, 2015

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 of the effects of monetary policy have the property that perfect foresight equilibria in which the nominal interest rate remains low forever necessarily involve low inflation (at least eventually) 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 consistent with the policy. We propose an explicit cognitive process by which agents may form their expectations of future endogenous variables. Under some circumstances, such as a commitment to follow a Taylor rule, a perfect foresight equilibrium (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 policies of the latter sort. According to the alternative approach that we recommend, a commitment to maintain a low nominal interest rate for longer should always be expansionary and inflationary, rather than causing deflation; but the effects of such “forward guidance” are likely, in the case of a long-horizon commitment, to be much less expansionary or inflationary than the usual PFE analysis would imply.

JEL Classification: E31, E43, E52

Suggested Citation

Woodford, Michael and Garcia-Schmidt, Mariana, Are Low Interest Rates Deflationary? A Paradox of Perfect-Foresight Analysis (September 5, 2015). Institute for New Economic Thinking Working Paper Series No. 18, Available at SSRN: https://ssrn.com/abstract=2667881 or http://dx.doi.org/10.2139/ssrn.2667881

Michael Woodford (Contact Author)

Columbia University, Graduate School of Arts and Sciences, Department of Economics ( email )

420 W. 118th Street
New York, NY 10027
United States

Mariana Garcia-Schmidt

Columbia University, Graduate School of Arts and Sciences, Department of Economics, Students ( email )

New York, NY
United States

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