Disinflation effects in a medium-scale New Keynesian model: Money supply rule versus interest rate rule

• Published in: European economic review Vol. 61; pp. 77 - 100
• Main Authors: Ascari, Guido, Ropele, Tiziano
• Format: Journal Article
• Language: English
• Published: Amsterdam Elsevier B.V 01-07-2013; Elsevier Sequoia S.A
• Subjects: Comparative studies; Disinflation; Economic theory; Inflation; Interest rates; Keynesian theory; Keynesianism; Monetary policy; Money supply; Sacrifice ratio; Welfare; Welfare economics; E5; E31; Sacrifice ratio; Welfare; Disinflation
• ISSN: 0014-2921; 1873-572X
• DOI: 10.1016/j.euroecorev.2013.03.004

Empirical studies show that successful disinflations entail a period of output contraction. Using a medium-scale New Keynesian model, we compare the effects of disinflations of different speed and timing, implemented through either a money supply rule or an interest rate rule. In terms of transitional output loss, cold-turkey disinflations under an interest rate rule are less costly than those under a money supply rule and are accomplished more rapidly. Furthermore, gradual or anticipated disinflations deliver lower sacrifice ratios. From a welfare perspective, despite the temporary economic contraction, the transitional welfare loss is quantitatively negligible, so that disinflations are overall welfare-improving. The overall welfare gain is not affected by how the disinflation is actually implemented: what really matters is the achievement of a permanently lower inflation rate.
•Compare disinflation realised through either a money supply or an interest rate rule.•Monetary policy strategy matters for the dynamics after a disinflation.•The theoretical sacrifice ratios are in line with empirical estimates.•Disinflations under an interest rate rule exhibit lower sacrifice ratios.•The overall welfare gain is not affected by how the disinflation is implemented.