NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

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

Mariana García-Schmidt, Michael Woodford

NBER Working Paper No. 21614
Issued in October 2015
NBER Program(s):Economic Fluctuations and Growth, Monetary Economics

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.

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Document Object Identifier (DOI): 10.3386/w21614

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