The Inflationary Bias of Real Uncertainty and the Harmonic Fisher Equation

We argue that real uncertainty itself causes long-run nominal inflation. Consider an infinite horizon cash-in-advance economy with a representative agent and real uncertainty, modeled by independent, identically distributed endowments. Suppose the central bank fixes the nominal rate of interest. We...

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Bibliographic Details
Published in:Economic theory 2006-08, Vol.28 (3), p.481-512
Main Authors: Karatzas, Ioannis, Shubik, Martin, Sudderth, William D., Geanakoplos, John
Format: Article
Language:English
Subjects:
Bank loans
Bias
Central banks
Consumption
Economic equilibrium
Economic theory
Economic uncertainty
Economics
Endowment
Endowments
Equilibrium
Expenditures
Fisher effect
Infinity
Inflation
Inflation rates
Interest rates
Liquids
Mathematical methods
Monetary economics
Monetary models
Prices
Studies
Uncertainty
Utility functions
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Summary:We argue that real uncertainty itself causes long-run nominal inflation. Consider an infinite horizon cash-in-advance economy with a representative agent and real uncertainty, modeled by independent, identically distributed endowments. Suppose the central bank fixes the nominal rate of interest. We show that the equilibrium long-run rate of inflation is strictly higher, on almost every path of endowment realizations, than it would be if the endowments were constant. Indeed, we present an explicit formula for the long-run rate of inflation, based on the famous Fisher equation. The Fisher equation says the short-run rate of inflation should equal the nominal rate of interest less the real rate of interest. The long-run Fisher equation for our stochastic economy is similar, but with the rate of inflation replaced by the harmonic mean of the growth rate of money.
ISSN:0938-2259
1432-0479
DOI:10.1007/s00199-005-0648-z