Are Low Interest Rates Deflationary? A Paradox of Perfect-Foresight Analysis

Abstract

We argue that an influential neo-Fisherian analysis of the effects of low interest rates depends on using perfect-foresight equilibrium analysis under circumstances where it is not plausible for people to hold expectations of that kind. We propose an explicit cognitive process by which agents may form their expectations of future endogenous variables. Perfect foresight is justified by our analysis as a reasonable approximation in some cases, but in the case of a commitment to maintain a low nominal interest rate for a long time, our reflective equilibrium implies neither neo-Fisherian conclusions nor implausibly strong predicted effects of forward guidance. (JEL D84, E12, E31, E43, E52)