Inflation targeting and output stabilization in an estimated monetary model

This paper studies determinacy conditions in a monetary model with an interest rate rule. In addition to the inflation rate as an argument of the policy rule, we introduce a second argument: output, a case empirically relevant but overlooked in the existing literature on monetary models with flexible prices. Firstly, we estimate a model with money in utility and the production function. We find that an aggressive response to inflation does not necessarily guarantee determinacy anymore. Secondly, we compare monetary policy in the pre-Volcker era and the post-Volcker era. We find that, after the appointment of Paul Volcker, the Federal Reserve started to respond more aggressively to inflation and less aggressively to output. Indeterminacy is pervasive: the equilibrium is indeterminate in both sub-samples. Thirdly, we estimate the impulse response functions. We find that monetary shocks, sunspot inflation shocks, and productivity shocks have long-lasting effects on inflation, output, and interest rates. • We study determinacy conditions in an estimated neoclassical monetary model. • The Taylor principle fails to ensure determinacy. • There is a “determinacy corridor”: only moderately aggressive monetary policy leads to determinacy. • Equilibrium was indeterminate before and after Volcker, despite the marked change in monetary policy. • Endogenous persistence created by indeterminacy helps to explain observed persistence in the data.