No. 867 - Disinflation effects in a medium-scale New Keynesian model.Money supply rule versus interest rate rule

Empirical studies show that successful disinflations entail a period of output contraction. Using a medium-scale New Keynesian model, we compare the effects of disinflations of different speed and timing, implemented through either a money supply or an interest rate rule. In terms of transitional output loss, cold-turkey disinflations under an interest rate rule are less costly than those under a money supply rule and are accomplished more rapidly. Furthermore, gradual or anticipated disinflations deliver lower sacrifice ratios. From a welfare perspective, despite the transitional economic contraction, disinflations are overall welfare-improving. Interestingly, the overall welfare gain is not affected by how the disinflation is actually implemented: what really matters is the achievement of a permanently lower inflation rate.