Trend inflation and macroeconomic stability in a small open economy

Abstract

This paper estimates a small open economy New Keynesian model for Australia with positive trend inflation while allowing for multiple equilibria. We first show the extent to which positive trend inflation can shrink the determinacy region. We then conduct a Bayesian estimation over two separate periods: from 1983Q1 to 1993Q1, covering the pre-inflation-targeting regime, and from 1993Q2 to 2018Q4, covering the inflation-targeting regime. We find that Australian monetary policy before the adoption of inflation-targeting permitted multiple equilibria and self-fulfilling inflation expectations to arise, resulting in exacerbated macroeconomic volatility. The implementation of inflation-targeting in Australia in the early 1990s successfully eradicated equilibrium multiplicity and sunspot shocks, and thereby drove the economy towards greater stability.