What are the economic effects of an interest rate cut when an economy is in the midst of a financial crisis? Under what conditions will a cut stimulate output and employment, and raise welfare?
We explore a hypothesis about the take-off in inflation that occurred in the early 1970s. According to the expectations trap hypothesis, the Fed was pushed into producing the high inflation out of fear of violating the public's inflation expectations.
We use the limited participation model of money as a laboratory for studying the operating characteristics of Taylor rules for setting the rate of interest. Rules are evaluated according to their ability to protect the economy from bad outcomes such as the burst of inflation observed in the 1970’s. Based on our analysis, we argue for a rule which: (i) raises the nominal interest rate more than one-for-one with a rise in inflation; and (ii) does not change the interest rate in response to a change in output relative to trend.
