In the New Consensus model, when monetary policy is sufficiently sensitive to changes in the rate of inflation, a standard Taylor rule can effectively pin down inflationary expectations and stabilize the economy at practically no output cost. It is often believed that assuming an open or a closed economy does not matter. This view is incorrect, and the result depends critically on the nature of devaluations. When devaluations are contractionary, standard Taylor rules do not work. This result holds in a standard New Consensus model and in an amended version of it. We suggest that a successful inflation-targeting regime for an open economy cannot rely only on the manipulation of a short-term interest rate.
In his 1975 paper, Tobin formalizes one of the main lessons from Keynes's General Theory: the idea that price flexibility is destabilizing. We propose a modified model à la Tobin by including rational expectations and staggered price setting, to show that under some conditions (a strong Tobin effect), there exist an infinite number of equilibrium paths that converge to equilibrium. Tobin was right: the most problematic assumption of modern macroeconomics is not rational expectations per se, but rather price flexibility and continuous market clearing.
Emiliano Libman and Gabriel Palazzo
This paper highlights the role of external indebtedness and the presence of inflationary inertia in order to assess the effectiveness and sustainability of inflation targeting during disinflation episodes. As the recent Argentinian experience illustrates, a sluggish inflation rate and a significant current-account deficit may make the stabilization process difficult. To illustrate the point, we build a model that shows that, when inflation adjusts fast, the target may be achieved without building too much external debt. But if inflation adjusts slowly, an excessive build-up of external debt could lead to an increase in the risk premium, a sudden shortage of foreign exchange, and the eventual collapse of the inflation-targeting regime.