Determinacy without the Taylor Principle
A long-standing issue in the theory of monetary policy is that the same path for the interest rate can be associated with multiple bounded equilibrium paths for inflation and output. We show that a small friction in memory and intertemporal coordination can remove this indeterminacy. This leaves no space for equilibrium selection by means of either the Taylor Principle or the Fiscal Theory of the Price Level. It reinforces the logical foundations of the New Keynesian model’s conventional solution (a.k.a. its fundamental or MSV solution). And it liberates feedback rules to serve only one function: stabilization.
For helpful comments and suggestions, we are grateful to Manuel Amador, Andy Atkeson, Marco Bassetto, V.V. Chari, John Cochrane, Yuriy Gorodnichenko, Patrick Kehoe, Narayana Kocherlakota, Stephen Morris, Emi Nakamura, Jon Steinsson, and seminar participants at Oxford University, UC Berkeley and VEAMS. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.