OFR, University of Auckland Researchers Create Model to Analyze Effects of Trend Inflation on Economic Stability

Views and opinions expressed are those of the authors and do not necessarily represent official positions or policies of the OFR or Treasury.

Francisco E. Ilabaca is an economist with the Office of Financial Research. Greta Meggiorini is an assistant professor of economics at the University of Auckland.

This OFR working paper, “Trend Inflation Under Bounded Rationality” presents a new model to analyze the effects of trend inflation on macroeconomic stability in New Keynesian models. Our key innovation is to incorporate more realistic assumptions about human decision-making in an otherwise standard macroeconomic model that features trend inflation. Our analysis has implications for monetary policy and central banking.

Traditional New Keynesian models use rational expectations to pin down the beliefs of households when they formulate their decisions. A consequence of this modeling choice is that households and firms place a lot of weight on events that are far in the future. As a result, even moderate amounts of trend inflation can lead to a more unstable economy—because inflation can be higher and more volatile—due to households and firms internalizing the trend when they make their consumption and pricing decisions.

However, empirical evidence in the lab and from studies of survey data show that rational expectations is a strong assumption because households and firms tend to be more myopic—meaning they place more weight on current events than on future events. In addition, the three decades of economic data before the pandemic featured generally low and stable inflation despite most central banks adopting positive inflation targets, implying positive trend inflation.

The authors introduce cognitive discounting into a standard New Keynesian model with trend inflation. They find that under reasonable assumptions, this can dampen the effects trend inflation has on macroeconomic stability. The model can also better explain the data because the authors conduct a full estimation and compare model fit with the standard trend inflation specification. The authors can better match the statistical moments of the data with their model, and the data prefer the authors’ specification featuring mild degrees of bounded rationality as well as trend inflation.

Policy Implications

The implications of this research are important for central bankers and policymakers interested in stabilizing macroeconomic outcomes, such as inflation and unemployment, through monetary policy. Understanding the effects of bounded rationality on the relationship between trend inflation and macroeconomic stability can help to further inform policymakers decisions about interest rates, forward guidance, balance sheet policies, and other tools available to central bankers. If trend inflation is less destabilizing, central banks have more room to maneuver when responding to high inflation.

The authors’ model shows that how expectations are specified can have important consequences in evaluating monetary policy. Their work shows that trend inflation may not be as destabilizing as previously thought. Given the connection between financial stability and monetary policy, particularly in recent financial stress episodes, more research is needed to understand the implications of these research results.