Recent research has shown that forward-looking Taylor rules are subject to indeterminacy in New Keynesian models with capital and investment spending. This paper shows that adopting a forward-looking Wicksellian rule that responds to the price level, rather than to inflation, is one potential remedy for the indeterminacy problem. This result is shown to be robust to variations in both the labor supply elasticity and the degree of price stickiness, the inclusion of capital adjustments costs, and if output also enters into the interest-rate feedback rule. Finally, it is shown that the superiority of Wicksellian rules over Taylor rules is not only confined to forward-looking policy, but also extends to both backward-looking and contemporaneous-looking specifications of the monetary policy rule.

This paper examines the local determinacy implications of using consumption taxes and income taxes to finance a balanced budget fiscal policy for a variety of popular monetary policy rules. It is shown using a New Keynesian framework that the severity of the indeterminacy problem that arises under each tax system depends not only on the specification of the interest-rate feedback rule, but also on the magnitude of the steady state tax rate, the steady state government debt–output ratio, and the degree of price stickiness. Significant differences in the determinacy criteria across the two tax systems are found to exist. The robustness of the results is assessed by extending the baseline model to include capital accumulation and the taxation of bond interest income. From a policy perspective, our results suggest that future shifts toward indirect taxation could have nontrivial implications for the setting of monetary policy under balanced budget rules, in particular the ability of the Taylor principle to achieve determinacy.

In sticky price models based on micro evidence that each period a fraction of prices are kept unchanged, recent studies reach the qualitatively equivalent conclusion that higher trend inflation is a more serious source of indeterminacy of rational expectations equilibrium, regardless of whether labor is firm-specific or homogeneous. This paper shows that the model with firm-specific labor is more susceptible to indeterminacy induced by high trend inflation than the model with homogeneous labor, because these two different specifications of labor lead to distinct representations of inflation dynamics. In addition, the model with firm-specific labor is more susceptible to expectational instability of the equilibrium caused by high trend inflation.

We propose a simple incomplete-markets small-open-economy model that is amenable to analytical dissection of its policy-relevant mechanisms. In contrast to its complete-markets limit, the equilibrium real exchange rate is irreducible from the incomplete-markets equilibrium. Market incompleteness exacerbates the domestic-inflation and output-gap monetary-policy trade-off in two ways: its steepness and its resulting endogenous cost-push to the trade-off. The latter depends on an equilibrium combination of structural shocks and on agents' beliefs of future events. Thus, in comparison to its complete-markets and closed-economy limits, standard Taylor-type rules are less capable of inducing determinate rational expectations equilibrium in our environment. Despite the larger policy trade-off under incomplete markets, simple policies that also respond to exchange-rate growth are able to manage expectations that drive the endogenous cost-push term. However, policies that respond directly to expectations may turn out to exacerbate the cost-push trade-off further, and thus, to be more likely to fuel self-fulfilling multiple or unstable equilibria.