The Inflation-Output Trade-Off Revisited

Abstract

This paper shows that at the zero bound of the short term nominal interest rate there is a strong trade-off between inflation and output, i.e., excess inflation has significant positive impact on output and employment. This remains true even if expectations have fully adjusted and inflation is anticipated. We show that even in a microfounded version of the well known New Classical example with a Phelps/Lucas/Kydland/Prescott style aggregate supply curve the trade-off between anticipated inflation and output is not zero as is sometimes suggested based upon the economic experience of the 1970’s. Instead the model solution features a well defined trade-off that may even approach infinity at which point the model collapses — due to a clash between aggregate demand and supply — and no solution exists. We offer tentative interpretations of this phenomenon.