Stabilizing Taylor rules and determinacy under unit root supply shocks: A re-examination

Abstract

I revisit the stabilizing and determinacy properties of Taylor-type policy rules in the canonical New Keynesian model when allowing for a unit root in the supply shock process. While able to offset inflationary pressure from non-stationary disturbances, interest-rate feedback rules that are unresponsive to fluctuations in the output gap necessarily produce unstable dynamics and explosive volatility for the latter. Specifically, rules fulfilling the Taylor principle are found to enforce the unique (non-stationary) equilibrium featuring well-anchored inflation expectations and immunity to sunspots; yet there exists no equilibrium predicting stationary behavior for both the inflation and output gap series, irrespective of whether the policy stance induces determinacy or indeterminacy. I show this property survives the adoption of forecast-based instrument rules, and also explore the relationship between Taylor-type rules and optimal discretionary policies in this particular New Keynesian environment.