Tight money policies and inflation revisited
This paper reconsiders the link between tight money policies and inßation in the spirit of Sargent and Wallace's (1981) influential paper "Some Unpleasant Monetarist Arithmetic". A standard neoclassical model with production, capital, bonds, and return-dominated currency is used to study the long-run effects on inflation of a tightening of monetary policy engineered via a open market sale of bonds. The potential for tight money policies to be inflationary (unpleasant arithmetic) is shown to exist even when the real interest rate is below the growth rate of the economy. Equilibria exhibiting unpleasant arithmetic can be stable. In contrast, when monetary policy is conducted via an inflation target rule, the only stable equilibrium is the one that exhibits pleasant arithmetic. The two monetary policy rules therefore produce sharply different predictions about the likely observability of unpleasant arithmetic in real-world economies.
This is a manuscript of an article published as Bhattacharya, Joydeep, and Noritaka Kudoh. "Tight money policies and inflation revisited." Canadian Journal of Economics 35, no. 2 (2002): 185-217. doi:10.1111/1540-5982.00127. Posted with permission.