Trend Inflation, Taylor Principle, and Indeterminacy

Positive trend inflation shrinks the determinacy region of a basic new Keynesian DSGE model when monetary policy is conducted by a contemporaneous interest rate rule. Neither the Taylor principle, which requires the inflation coefficient to be greater than one, nor the generalized Taylor principle, which requires that the nominal interest rate should be raised by more than the increase in inflation in the long run, is a sufficient condition for local determinacy of equilibrium. This finding holds for different types of Taylor rules, inertial policy rules and price indexation schemes. Therefore, regardless of the theoretical set up, the monetary literature on interest rate rules cannot disregard average inflation in both theoretical and empirical analysis.