Is Moderate-to-High Inflation Inherently Unstable

The data across time and countries suggest the level and variance of inflation are highly correlated. This paper exam-ines the effect of trend inflation on the ability of the monetary authority to ensure a determinate equilibrium and inflation stability in a sticky-price model. Trend inflation increases the importance of future marginal costs for current price setters in a staggered-price-setting model. The greater importance of expectations makes it more difficult for the monetary authority to ensure stability in two senses. First, equilib-rium determinacy is more difficult to achieve through rea-sonable specifications of nominal-interest-rate (Taylor) rules at moderate-to-high levels of inflation (e.g., at levels around 4 percent per year). In addition, the volatility of inflation induced by cost-push shocks is, all else equal, higher at higher rates of inflation under a reasonable specification of the nominal-interest-rate rule. If monetary policymakers have fol-lowed these types of policy rules in the past, these results may explain, in part, why moderate-to-high inflation is associated with inflation volatility. JEL Codes: E3, E5. ∗The author would like to thank two anonymous referees and participants in seminars at the Federal Reserve Board and North American Summer Meetings of the Econometric Society in 2004 for their comments. The author would also like to thank Hasan Bakshi and Pablo Burriel-Lombart for discussions that led to thi