Price Level Determinacy with an Interest Rate Policy Rule and Rational Expectations

Abstract

This paper reconsiders a result obtained by Sargent and Wallace, namely, that price level indeterminacy obtains in their well-known model if the monetary authorities adopt a policy feedback rule for the interest rate rather than the money stock.Since the Federal Reserve seems often to have used the federal funds rate as its operating instrument, with the money stack determined by the quantity demanded, this result suggests that the Sargent-Wallace model --as well as others incorporating rational expectations --is inconsistent with U.S.experience.It is here shown, however, that the indeterminacy result vanishes if the interest rate rule is chosen so as to have sonie desired effect on the expected quantity of money demanded.This revised conclusion holds even if considerable weight is given, in the choice of a rule, to the aim of smoothing interest rate fluctuations.

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