DP8956 | The Effect of Conventional and Unconventional Monetary Policy Rules on Inflation Expectations: Theory and Evidence

Author(s)

Publication Date

23/05/2012

JEL Code(s)

Keyword(s)

Programme Area(s)

Abstract

This paper has three parts. Part 1 constructs a classical economic model of inflation, augmented by a complete set of financial markets; I call this the core monetary model. Part 2 develops a series of calibrated examples to illustrate how the core monetary model explains the history of inflation after WWII and Part 3 provides evidence to show that the unconventional monetary policy, followed in the wake of the 2008 financial crisis, was effective in stabilizing inflation expectations. The core monetary model provides a unified framework to explain how an interest rule can be used to control inflation in normal times, and to explain the purpose of unconventional monetary policy when policy attains the zero lower bound. I argue that management of the variation in the composition of the Fed?s balance sheet, is an important tool in a central bank?s arsenal that can be used to help prevent deflation in the wake of a financial crisis.