The weak correlation of inflation and the nominal interest rate is an economic phenomenon known as the Gibson paradox. The name Gibson paradox was suggested by Keynes (1930) in honor to A.H.
As shown below, these extensions are mainly motivated because the cash-less SW model falls short in replicating the Gibson paradox.
Our paper analyzes the swings in inflation dynamics around the early 1990s with a special focus on the determinants of the Gibson paradox.
The results show that the inflation moderation starts in the early 1980s, but the lowest correlation between inflation and the nominal interest rate (Gibson paradox) is found for a sample window starting around 1991.
Next, the rolling-window estimation and a business cycle analysis comparing two distinctive sample periods will help us identify the changes leading to the resurgence of the Gibson paradox.
To illustrate the differences in the latter, Table 1 reports the posterior mean values together with the 5%-95% uncertainty bands of the posterior distribution for two representative subsamples: the initial 20-year rolling-window subsample 1961-1981 and the 1991-2011 subsample featuring the Gibson paradox. (15)
As also reported in Table 3, the model reproduces rather well the mild comovement between nominal interest rates and inflation observed in the 1991-2011 period (Gibson paradox).
whereas for the subsample when the Gibson paradox occurs (1991-2011) the estimated NKPC is:
As shown in Table 1, [[xi].sub.p] = 0.50 in the 1961-1981 sample period, and [[xi].sub.p] = 0.81 in the Gibson paradox period (1991-2011).
Looking across numerical estimates of Table 1, the decline in money demand inertia, [[lambda].sub.m], and in the transaction cost elasticity, [a.sub.2], partially explains a higher interest-rate elasticity during the Gibson paradox period (1991-2011), though the severe fall of the long-run nominal interest rate is the most influential change.
This weaker reaction of the nominal interest rate to inflation contributes to explaining the Gibson paradox during the 1991-2011 period.