New-Keynesian Inflation Control Is Equilibrium Selection

How do central banks lower inflation by raising interest rates? Separating policy into an interest-rate path and an equilibrium-selection choice clarifies how models answer this question. In the standard new-Keynesian model, higher interest rates raise inflation. Inflation only declines with a coincident negative equilibrium-selection shock. Taylor rules with a specific disturbance path seem to unite interest rates and equilibrium selection. But multiple Taylor rule disturbances can produce different inflation with the same interest-rate path. The choice of disturbance process consistent with an interest-rate path is thus the independent equilibrium-selection choice. With short-term debt, lower inflation requires a fiscal tightening. With long-term debt, a sufficiently persistent interest-rate rise can temporarily lower inflation with no change in primary surpluses. The standard new-Keynesian model does not embody old-Keynesian intuition: Higher interest rates lower output and employment, and via the Phillips curve lower inflation, all going forward.