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The Output Effect of a Transition to Price Stability When Velocity Is Time Varying

Authors


  • We are grateful to Anurag Banerjee, Parantap Basu, Stephen Millard, Charles Nolan, and Les Reinhorn for helpful discussions; and to participants at a CCBS Bank of England seminar, 2007, the 2008 MMF conference at Birkbeck College, London and the 2009 RES conference at Surrey University for useful comments. Special thanks to an anonymous referee for insightful comments and suggestions that have helped improve the paper. The usual disclaimer applies.

Abstract

This paper explores the effect of time-varying velocity on output responses to policies for reducing/stopping inflation. We study a dynamic general equilibrium model with sticky prices in which we introduce time-varying velocity. Specifically, we endogenize time-varying velocity into the model developed by Ireland (1997) for analyzing optimal disinflation. The nonlinear solution method reveals that, depending on velocity, the “disinflationary boom” found by Ball (1994) may disappear even under perfect credibility and that early output losses may be much larger than previously thought. Indeed, we find that a gradual disinflation from a low inflation may even be undesirable.

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