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Price level targeting versus inflation targeting in a

forward looking model


David Vestin
IIES, Stockholm University
First draft: June 1999
This draft: January 2000
Preliminary - Comments Welcome

Abstract
This paper examines a price level target in a model with a forward-looking CalvoTaylor Phillips curve. Contrary to conventional wisdom, it is found that price level
targeting leads to a better inflation- output-gap variability tradeo than inflation
targeting, when the central bank acts under discretion. In some cases, price-level
targeting results in the same equilibrium as inflation targeting under commitment.

Introduction

The conventional wisdom emerging from the price level targeting discussion seems to
be that price level targeting is bad because it generates unnecessary variability in the
output-gap. Some recent papers have debated the relative merits of inflation targeting
and price level targeting. Various results and indications that to some extent casts doubt
on this conventional wisdom can be found in those papers. Svensson [15] found that price
level targeting delivers a better outcome (lower variability of inflation) than inflation
targeting when the central bank is unable to commit. This result holds for a Lucastype Phillips curve and requires some (realistic) output-gap persistence. Woodford [16]
found that for an inflation targeting central bank, the optimal policy under commitment

E-mail: david.vestin@iies.su.se. I thank Lars E.O. Svensson for extensive comments on previous
drafts. I have also benefited from discussions with, and comments from Henrik Jensen, Paul Klein,
Stefan Lasen, Marianne Nessen and Per Pettersson and participants at seminars at the IIES, Stockholm
University, Oslo University and the Swedish Central Bank.

is characterized by a significant degree of interest rate inertia. Woodford results suggest


that given a central bank with no commitment, assigning a loss-function with the interest
rate as an explicit argument induces the central bank mimic the commitment solution
to some extent, since under the new loss-function there is an explicit reason to smooth
interest rates. Jensen [6] finds that in some instances, nominal income growth targeting
can dominate inflation targeting because of the same reason as in Woodfords paper,
namely that it introduces the inertial behavior of interest rates that is a feature of the
commitment solution.
Importantly, both Clarida, Gali and Gertler [2] and Woodford [16] finds that the price
level is stationary under commitment. This directs attention to the possibility that an
explicit price level target might be preferable when the central bank acts under discretion
(because the price level is stationary when there is a price level target).
This paper compares price level targeting with inflation targeting under discretion, and
finds that it is possible to improve the outcome of the discretionary inflation targeting
case by assigning a price level target to the central bank. Thus, the question is the same
as in Svensson [15], but posed in a model where forward looking behavior is emphasized.
The emphasis on forward looking elements will turn out to play an important role when
thinking about price level targeting.
Clarida, Gali and Gertler [2] have recently stressed that in forward looking models,
gains from commitment are possible also when the central bank aims at the natural rate
of unemployment. This paper thus makes an attempt to see whether these benefits can
be reached even when no commitment device exists.
The main result is that price level targeting delivers a more favorable trade-o between inflation and output-gap variability than inflation targeting. With no (exogenous)
persistence in the inflation process it is always possible to implement the commitment
solution fully by assigning an appropriate price level targeting regime.
The mechanism behind these results is the restraining eect of expectations. The
private sector realizes that the central banks incentive to oset shocks increases with a
price level target, since the price level is persistent. Therefore, the central bank is helped
by reduced expectations about future inflation when the economy is hit by an inflationary

shock.
The paper proceeds as follows. Section 2 presents the model. Section 3 contains a
summary of the optimal policy for the dierent regimes. Comparisons are made in section
4. Section five presents some conclusions.

The forward looking model

The model has the following standard Phillips curve that relates inflation, , to the
output-gap, x, and expected future inflation, t+1|t 1
t = t+1|t + xt + ut ,

(1)

where ut is an exogenous shock. Equation (1) is the central equation in what has become a
work-horse model, dating back to Calvo [1], recently derived and extended by Rotemberg
and Woodford [10] and thoroughly examined in Clarida, Gali and Gertler [2]. Inflation
today is aected by two components. First, because of price rigidity, expected future
inflation enters. Secondly, because of monopolistic competition, prices reflect the marginal
cost conditions. In the model, this is captured by the inclusion of the output-gap, acting as
a proxy for labor-market conditions that aect wages and thus the marginal cost. Finally,
the cost push shock can be viewed as anything aecting real marginal cost working
through channels other than the output-gap.
This model can be contrasted with the model in Svensson [15], which is of Lucas-type.
In that model it is the inflation surprise that aects the output-gap. In this model, it is
the expected future inflation that drives the results. Thus, the model puts much emphasis
on the forward looking elements of monetary policy.
At this stage, I choose to abstract from transmission lags and, what the literature have
labeled, endogenous persistence. Although these issues are an important part of practical
monetary policy making, the main focus of the paper is to examine the eects of forward
looking behavior. Gali and Gertler [5] finds empirical support for the relevance of forward
looking behavior, whereas Fuhrer [4] questions its importance.
1

The notation t + 1|t means conditional expectation of t + 1 given information at t.

Many empirical papers find that in order to fit the data, some persistence in the
inflation process must be introduced. To avoid ignoring this issue completely, following
Clarida, Gali and Gertler [2], I introduce exogenous persistence in the cost push shock
captured by an AR(1) process. Thus,
(2)

ut = ut1 + t

t N 0, 2 .

The Phillips curve is often coupled with an equation relating the interest rate to
the output gap. However, unless interest rate smoothing is considered, this equation is
redundant for solving the model in the sense that the problem is separable. First, a
solution to the model is found treating the output gap as the control variable (instead
of the interest rate). Then, the redundant equation is used to find the path of the
nominal interest rate that is consistent with the optimal output gap path. If interest rate
smoothing (captured by adding an interest rate term to the loss function) is considered,
the problem is no longer separable. This is because then, the variability of the interest
rate must be explicitly weighted against the variability of the output-gap and inflation,
and the variability of the interest rate depends on the elasticity of the output-gap with
respect to the interest rate. For the purpose of this paper, since interest rate smoothing
is not considered, the Phillips curve gives a complete description of the dynamics that is
of interest.
The central bank behavior is assumed to be captured by minimizing
min Et (1 )
xt

X
i
i=0

Lt+i

(3)

where Lt will take dierent forms depending on whether inflation targeting or price level
targeting is pursued. It is assumed that the loss-function of society takes the form
Lt = 2t + x2t
To evaluate dierent policies, we will be interested in the average performance, measured
by the unconditional expected value of the loss function. To simplify exposition of many of
4

the results in this paper, it is convenient to express the loss function in terms of variances
of inflation and the output gap. Appendix G explains that when 1 we get the
following interpretation of the expected value of (3)
E (Lt ) = Var ( t ) + Var (xt ) .
In what follows, two dierent regimes for conducting monetary policy will be considered. One way to think about these regimes is in terms of delegation in the sense of
Rogo [9]. Society delegates a regime (defined in terms of a loss-function) to an independent central bank. Assuming that this delegation is enforceable, for example by finding a
central banker with appropriate preferences or by conditioning re-election of the governor
on performance evaluated against the assigned objectives, the implications of the dierent
regimes are explored. Each regime will imply a dierent response to shocks which in turn
will imply dierent time series properties for inflation and the output-gap. Given the
interpretation of the loss-function discussed above, we will focus on the variance of inflation and the output-gap. The relative performance of the two regimes will be evaluated
against the true social loss function. In particular we will assume the existence of a true
, the relative weight on output-stabilization.
The central bank is assumed to lack commitment, in the strict sense of not being able
to credible announce future actions inconsistent with the assigned loss function. Nevertheless, the commitment solution for the social loss-function is calculated as a benchmark,
to see how close the dierent discretionary policies comes this optimal solution. To be
able to evaluate the social loss-function, the next section calculates the implied variances
of inflation and the output gap for each of the cases.

Solving the model

The preferences of society regarding the trade-o short run trade-o between inflation
and the output-gap is described by one of the following loss function.
Lt = 2t + x2t

(4)

In the case of inflation targeting, the above loss function is assigned to the central bank.
As an alternative, the central bank could be instructed to enforce a price level target.
Formally, this would correspond to assigning the following loss function.
2
Lt = p2t + x
t

(5)

It is important to note the distinction between these two loss functions. The first one
is corresponds to the true preferences, the second does not. Later in the paper, the
dierent strategies for monetary policy will be evaluated against each other. This may be
interpreted as what Svensson [13] refers to as flexible inflation (price level) targeting.
It will be possible to express the optimal choice of the output gap (the control variable)
and the evolution of the price level (the state variable) on a similar form in all three cases.
xt = cpt1 dut
pt = apt1 + but
where a, b, c and d will be determined by minimizing the respective loss-function defined
by (4) and (5). Furthermore, appendix B shows that given a < 1, the variance of inflation
and the output-gap will take the form2
Var ( t ) = e2 2u

(6)

Var (xt ) = f 2 2u

(7)

e=

f=

2b2 (1 )
(1 a) (1 + a)

b2 c2 (1 + a) + d2 (1 a2 ) (1 a) + 2bcd (1 a2 )
(1 a2 ) (1 a)

The rest of this section examines the dierent cases. First, we consider the social benchmark, that is, inflation targeting under commitment. It is assumed that it is not possible
to commit, and thus the next paragraphs examines inflation targeting and price level
targeting under discretion.
2

This will be true for inflation targeting under commitment and for price-level targeting. For inflation

targeting under discretion, a = 1 and then the variance calculation is trivial, as will be clear from the
next section.

3.1

Social benchmark: Inflation targeting under commitment

In the first best case, the central bank has complete credibility and is able to commit.
Thus, it can credible announce any future path for the output gap, and thus aect the
public sector expectations about future inflation with these statements. In this paper,
it is assumed that this is not the environment the central bank faces in reality. That
is why the next section deals with discretion. However, it is interesting to calculate the
commitment case as a benchmark to use for evaluation of the regimes under discretion.
Following Currie and Levine [3], Woodford [16] and the appendix in Clarida, Gali and
Gertler [2], define the following Lagrangian.
(
)
X i

min Et
2t+i + x2t+i + t+i ( t+i xt+i t+i+1 ut+i )
{xi }
2
i=t
i=0
As showed in appendix C, the optimal policy, represented by the optimal choice for the
output gap (the control variable) is given by
xt = c pt1 d ut
with
(1 a ) (1 a )

1 b [1 + (1 a )]
=

c =
d

a () =

( (1 + ) + 2 ) 1

1 4

b =

(1+)+2

(8)

a
1 a

This choice of the output gap gives an evolution of the price level given by
pt = a pt1 + b ut

(9)

Appendix F shows that


lim a () = 0

lim a () = 1.

Thus, the price level is stationary except in the special case when limit when the central
bank only cares about stabilizing the output-gap ( ).

Consider a one-time positive shock to the inflation rate. Since c > 0, the optimal

policy requires the central bank to maintain the control variable (the output gap) below
the steady state value (of zero) as long as the (log of the) price level remains above the
steady state value (zero) even when no further shocks hit the economy. This is the gradual
response that Woodford and Clarida et.al. found. As we shall see later, this will not be
the case under discretionary inflation targeting, but it will turn out to be the case with a
price level target. In the case of inflation targeting with commitment, the intuition is that
with a gradual (credible) response, it is possible to aect expectations of future inflation
through the forward-looking component of the Phillips curve and thereby reducing the
amount of activism needed to stabilize inflation.
Using a , b , c and d in (6) and (7) gives

3.2

V ar ( t ) = (e )2 2u

(10)

V ar (xt ) = (f )2 2u

(11)

Inflation targeting, discretion

Next, let us turn to the discretionary setting. Since no credible promise can be made,
and there is no endogenous state variable under inflation targeting discretion, the value
function can be written as

1 2
2
V (ut ) = Et min t + xt + V (ut+1 )
xt 2

= 0 + 1 ut + 2 u2t
2
where the minimization is subject to (1). The control variable xt will be a linear function
of the exogenous variables. Also, the forward looking variable (being a linear function of
8

the exogenous variable and the control variable) will have the form (a = 1, b
c = 0).
t = but

(12)

t
xt = du

(13)

Appendix D shows that

+ (1 )

b =
d =
2

+ (1 )
b =

Thus, a positive shock to inflation will to some extent be oset by a negative output-gap.
For later comparison, it is convenient to rewrite (12) in terms of the price level.
pt = pt1 + but

(14)

>From (12) and (13) it is evident that


Var (t ) = b2 2u

(15)

Var (xt ) = d2 2u

(16)

with
2u =

3.3

1
2
1 2

Price level targeting

In this section a price level target is considered.34 The loss-function takes the form
Lt =
3

1 2 2
p + xt
2 t

It is possible to consider a trend in the price level by defining the loss function as the deviation of

the price level from trend. This will not aect the variances of inflation and the output gap.
4

It can be shown that an inflation bias generated from an overambitious output-gap target (not present

in this paper) can be removed with an appropriate selection of the (time-dependent) price level target.
This case is discussed in Kiley [7].

is the weight delegated to the central bank together with the price level target.
where
When society delegates the loss function, there is no reason why the relative weight on
output stabilization must equal the true weight. Rogo [9] showed that assigning a lower
than societys true value (that is, a more conservative central banker) eliminated the
inflation bias. Here, no bias is present, since we assumed that the output-gap target was
consistent with the natural rate of unemployment. However, as will be clear from the
will aect the trade-o between inflation and outputresults below, dierent values of
gap variability (whereas Rogos result was in terms of the level of inflation).
Rewriting the Phillips curve (1) in terms of the price level yields

pt pt1 = xt + pt+1|t pt + ut

To solve the model, note that in this case there are two state variables. As in the case of
inflation targeting, the shock is one of them. However, the price level from the previous
period also enters as a state variable. Intuitively, this is because actions aecting the
price level will persist. In the case of inflation targeting, an increase in inflation today
will not aect inflation tomorrow, whereas an increase in the price level today will aect
the price level tomorrow. This helps clarifying the dierence between a price level target
and targeting inflation at zero. In the latter case, a temporary deviation from the target
will not aect future losses. In the price level targeting case, a temporary deviation from
target will have to be countered with an osetting deviation in the future.
With two state variables, the loss-function will take the following form:

1 2 2
p + xt + V (pt , ut+1 )
V (pt1 , ut ) = Et min
xt
2 t
ut = ut1 + t
Appendix E shows that the state variable we are interested in will also be a linear function
of the state variables
pt = apt1 + but
where the coecients are defined by the following equations:

a =
+
(1 a)
2 + 2
10

(17)

b =

i
+
b 1 + b + b

+
(1 a)
2 + 2

(18)

= 1 + (1 a
)
Note that a
is independent of , the degree of persistence in the shock process.
What will turn out to be important is that precisely in the same way as for the inflation
targeting case under commitment, it is possible to show that

= 0
lim a

0

= 1.
lim a

This exercise is done in appendix E. Notice that this means that the price level follows an
AR(1) process and is stationary. Also, note that if there is no persistence in the residual
process (i.e. = 0) then a = b. The solution for the control variable xt is given by
t
xt =
cpt1 du
where
(1 a
) (1 a
)

1 b [1 + (1 a
)]
d =

c =

Similar to the previous section, to find the variances of inflation and the output-gap, use
a
, b, c and d in (27) and (28).

V ar ( t ) = e2 2u

(19)

V ar (xt ) = f2 2u

(20)

Comparing results

The main purpose of this paper is to examine the relative performance of an inflation
target to a price level target. The essential insight is gained from comparing (17) with
(9) and (14).
11

Defined in
ITC

pt = a pt1 + b ut

(9)

ITD

pt = apt1 + but

(14)

PTD pt = apt1 + but

(17)

These equations define the optimal solution in terms of the price level for inflation
targeting under commitment and discretion, and price level targeting under discretion.
All other results such as variances of inflation and the output gap will be based on these
equations. An implication of this is that if we can show that equations (9) and (17) are
the same we know that the commitment solution can be implemented by assigning a price
level target under discretion.
To preview the results, this is almost what we will find. When there is no persistence
( = 0) the commitment solution can be fully implemented with a price level target.
and
under price level targeting such that a () = a
()
That is, it is possible to find a

b () = b().
In some of the experiments considered below, a numerical value for is needed.
Roberts [8] estimates a version of the model above (eq. 9 p. 979):
t = t+1|t + xt + t
and finds in the range of 0.25 to 0.36 depending on the measure of inflation expectations.
On the basis of that result, I chose = 13 .

4.1

No persistence ( = 0)

The main result of the paper is that price level targeting gives a better trade o between
inflation- and output gap variability than inflation targeting. Later, this result will be
proved for the case of persistence in the residual process. To gain understanding of this
result, we start by first considering the special case of = 0. With this assumption, it is
possible to find an analytical solution for the price level targeting case.
Proposition 1 With no persistence in the residual process, the commitment solution can
be implemented by assigning a price level target with a dierent .
12

such that
With = 0, a = b and a
= b, so it is enough to prove that we can find a
In fact, the preceding sections already provided the information needed to
a () = a
().
pursue this argument. To recapitulate:
= 0
()
lim a

= 1
lim a
()

lim a () = 0

lim a () = 1

Thus, since both the coecient a


from the price level targeting case (eq. (??)) and
the counterpart from the commitment case (eq. (8)) is limited by the interval [0, 1) we
know that for a given value of , implying a fixed value for a () it is always possible
that sets a
= a (). That is, it is always possible to implement
to find a value of
()
the commitment solution for an inflation target by assigning a price level target with a

dierent (namely ).

4.2

Persistence

With persistence in the residual process, we have two conditions that must be satisfied in
order to implement the inflation targeting commitment solution with a price level target:
= a ()
a()
b()
= b ()
Figure 1 and 2 gives the a and b coecient values for the dierent cases, for dierent
values of . Examining these figures reveals that it is not possible to perfectly replicate
the commitment solution with a price level target. This does not mean that an inflation
target is preferred, it only suggest that full commitment through a price level target is not
available when > 0. To find out whether the price level target dominates the inflation
target we will find the policy frontiers for the two cases. To do this, both the variance of
inflation and the output-gap must be recovered under the two regimes.
13

The a coefficient, =0.33333, =0.5


ITD
1

0.8
ITC
PTD
0.6

0.4

0.2

0.5

1.5

2.5

Figure 1:

The b coefficient, =0.33333, =0.5


2
1.8
ITD

1.6
1.4

ITC

1.2
PTD

1
0.8
0.6
0.4
0.2
0

0.5

1.5

Figure 2:

14

2.5

Variance of inflation, =0.33333, =0.5


5
4.5
4
ITD
3.5

Var()

3
2.5
ITC

2
1.5

PTD
1
0.5
0

0.5

1.5

2.5

Figure 3:

4.3

Variance results

To summarize, the variance of inflation under inflation targeting and price level targeting
is given by (15), (10) and (19). Similarly, the output gap variances are given by (16), (11)
and (20) respectively.
Var ( t ) Var (xt )
ITD

b2 2
u

d2 2u

ITC

(e )2 2u

(f )2 2u

PTD e2 2u

f2 2u

In Svensson [15], comparing the two cases is more clear-cut since there is no dierence
in output gap variability. In the forward looking case, this is not true. Both output gap
and the inflation variability will dier under the two regimes and thus it is hard to judge
the result by just inspecting the equations.
To interpret previous findings in the literature, examine the following variance plots.
>From these figures, it is tempting to make the conclusion that price level targeting
generates higher output-gap variability that does inflation targeting. This conclusion is
reached by fixing and vertically examining figure 4. This leads Kiley [7] to conclude that
15

Variance of the output-gap, =0.33333, =0.5


4

3.5

Var(y)

2.5

1.5
PTD

ITC
ITD

0.5

0.5

1.5

2.5

Figure 4:
a price level target is worse than an inflation target, since it generates higher variability
of the output-gap (he compares to Svensson [14] who finds that (given some conditions)
a price level target gives the same variability of the output-gap as does an inflation
target, but a lower variability of inflation and thus concludes that a price level target is
preferable). However, the same experiment in figure 3 reveals that the variance of inflation
is lower with a price level target that with an inflation target. It thus seems inconclusive
which is the better. This paper suggests is that it is more instructive to read the figure
horizontally. A given variance of inflation resulting from a particular value of can always
under a price level target. It is not obvious
be implemented by assigning a dierent value
that both the variance of inflation and the output-gap under price level targeting can be
made smaller compared to inflation targeting (both under discretion) simultaneously by
inspecting the figures. To evaluate this, the next section plots eciency frontiers.

4.4

Eciency frontiers

An illustrative way of describing the implications of the two regimes is by plotting the
frontiers in the two dimensional space of inflation- and output-gap variance. A frontier

16

Policy frontier, =0.33333, =0.5


12

Variance of outputgap

10

4
ITD
ITC

PTD

0.5

1.5

2
2.5
3
Variance of inflation

3.5

4.5

Figure 5:
plots all combinations of output gap variance and inflation variance that are attainable
for dierent values of the preference parameter . Since there is a tension between these
variances, there will always be a trade-o of increased inflation variability in order to
reduce output gap variability. Technically, the frontiers are constructed by fixing and
then plotting inflation variance and output-gap variance for dierent values of . With
1, the slope of the eciency frontier is equal to .
Proposition 2 Price-level targeting gives a better inflation- output-gap variance trade-o
than inflation targeting.
Figure 5 reveals that price level targeting dominates inflation targeting (when the
central bank acts under discretion) since the frontiers never cross. Thus, in the absence of
commitment it is preferable to use a price level target. Note that the variance frontiers for
inflation targeting and price level targeting almost coincide. If persistence is increased up
to almost one, there will be a more pronounced dierence in the two cases, but the price
level target will sill dominate the inflation target.5 From an economic point of view, a price
5

For very high values of , there will be a discrepancy between the commitment case and the price level

targeting case. However, the price level target will still dominate the inflation target under discretion.

17

level target adds credibility in the following sense: Under an inflation target, a temporary
increase in inflation is disregarded in the next period. With a price level target, this is
no longer true. Instead, a temporary increase in inflation must be countered sooner or
later by a reduction in inflation below target. This has been used as an argument against
using price level targets, and the claim is that it would increase volatility of inflation.
However, with a forward looking agents, the anticipated reduction that must take place
in the future reduces inflationary expectations and thus helps the central bank to fight
inflation.

4.5

Interpreting

When Rogo found that assigning a less than the one found in the social welfare function, the interpretation was that a more conservative central banker should be appointed.
> means that a less
Therefore, it is tempting to draw the conclusion that finding
conservative central banker should be appointed. However, this is premature. The reason
have dierent interpretations as can be seen from comparing the two
is that and
loss-functions, for convenience reproduced in terms of variances.
E [Lt ] = Var ( t ) + Var (yt )

(yt )
E [Lt ] = Var (pt ) + Var
In the first loss-function, can be interpreted as the relative weight placed on the variability of the output-gap compared to the variability of inflation. In the case of price
measures the relative weight placed on output-gap variability compared
level targeting,
to the variability of the price level. Since the two weights have dierent benchmarks, not
much is gained from comparing their absolute values. However, since the inflation rate
is tightly linked to the price level, it is possible to interpret the relative size of the two
weights. The simplest case is when = 0. The price level follows
pt = apt1 + but

18

With no persistence in the residual process, ut evaluating the variance expressions (26)
and (27) result in
b2
Var (pt ) =
2u
2
1a

Var ( t ) =

2b2 2

1+a
u

Thus, by taking the ratio we get


2 (1 a2 )
Var ( t )
=
Var (pt )
1+a

or
Var (pt ) =

1
Var ( t )
2 (1 a)

In order to get a comparable weight (i.e. to have the same normalization in both
loss-functions) the following equation must be satisfied:

= 2 1a



imply that the central bank should be more conservative.
That is, a > 2 1 a

Conclusions

The main result of the paper is that in a forward looking model used by several authors,
a price level target dominates an inflation target even when preferences are concerned
with the variability of inflation and the output-gap. The result can be interpreted in line
with Rogos classic result that by assigning a loss-function dierent from societys (in
Rogos case, a more conservative central banker in the sense that banker < society ), a
better outcome can occur. In this case there is a two-dimensional assignment. First,
the inflation target is replaced by a price level target. Second, a dierent value of is
assigned. In previous literature there has been a misinterpretation of the eects of a
price level target. There, it is recognized that for a given value of , a price level target
generates more variability of the output-gap than does an inflation target. But, it is also
19

recognized, inflation variability is lower under the price level target. Conventional wisdom
explained this result by claiming that in the price level targeting case, a positive shock
must later be countered by a monetary tightening, which will induce more volatility of
the output-gap than in the inflation targeting case where bygones are treated as bygones.
The point of this paper is that this comparison is not the most interesting. By instead
examining the policy frontiers, it is clear that the price level target dominates the inflation
target since it is always possible to implement a better outcome by assigning a dierent
in the price level targeting case. With no persistence, the commitment solution of the
inflation targeting case can be implemented. With persistence, this is not true. However,
it is still always the case (in the model examined!) that a price level target generates
a better outcome than the inflation target, and is almost as good as the commitment
solution. With price level targeting, the private sector expects the central bank to counter
an above average inflation (normalized to zero in this paper) with a below average inflation
somewhere in the future. In other words, a positive shock to inflation reduces the expected
future inflation and thus lowers the amount of intervention the central bank must engage
in.

20

References
[1] G. Calvo. Staggered prices in a utility-maximizing framework. Journal of Monetary
Economics, 12:38398, 1983.
[2] Richard Clarida, Jordi Gali, and Mark Gertler. The science of monetary policy.
Journal of Economic Literature, page ?, Forthcoming 1999.
[3] D. Currie and P. Levine. Rules, Reputation and Macroeconomic Policy Coordination.
Cambridge University Press, 1993.
[4] Jerey C. Fuhrer. The (Un)Importance of forward-looking behaviour in price specifications. Journal of Money, Credit and Banking, 29(3):338350, 1997.
[5] Jordi Gal and Mark Gertler. Inflation dynamics: A structural econometric analysis.
Journal of Monetary Economics, forthcoming.
[6] Henrik Jensen. Targeting nominal income growth or inflation? mimeo, University of
Copenhagen, June 1999.
[7] Michael T. Kiley. Monetary policy under neoclassical and new-keynesian phillips
curves, with an application to price level and inflation targeting, May 20 1998.
[8] John M. Roberts. New keynesian economics and the phillips curve. Journal of Money,
Credit, and Banking, 27(4):975 984, 1995.
[9] Kenneth Rogo. The optimal degree of commitment to an intermediate monetary
target. Quarterly Journal of Economics, 100:11691190, 1985.
[10] Julio Rotemberg and Michael Woodford. An optimization-based econometric framework for the evaluation of monetary policy. NBER Macroeconomics Annual, 1997.
[11] Glenn Rudebusch and Lars E.O. Svensson. Policy rules for inflation targeting. In
Monetary Policy Rules, pages 203 262. NBER, 1999.
[12] Frank Smets. What horizon for price stability? mimeo, European Central Bank,
August 1999.
21

[13] Lars E.O. Svensson. Inflation forecast targeting: Implementing and monitoring inflation targets. European Economic Review, 41(6):11111146, 1997.
[14] Lars E.O. Svensson. Price stability as a target for monetary policy: Defining and
maintaining price stability. Mimeo, Stockholm University, IIES, March 1999.
[15] Lars E.O. Svensson. Price level targeting vs. inflation targeting. Journal of Money,
Credit and Banking, 1999, forthcoming.
[16] Michael Woodford. Optimal monetary policy inertia. NBER Working Paper no.
7261, August 1999.

22

Finding c and d

To get the c and d coecients when the price level follows


pt = apt1 + but
use the stationary version of (42) in (43) and simplify to get
1 a
1 b (1 )
(bpt1 + but pt1 )
ut

(1 a) (1 a)
1 b [1 + (1 a)]
=
pt1
ut

= cpt1 dut

xt =

Variance calculations

This appendix calculates the variance for inflation and the output-gap given a model
implying an evolution of the price level of the form
pt = apt1 + but

(21)

yt = cpt1 + dut

(22)

Subtracting pt1 from (21) gives


t = (1 a) pt1 + but
Var ( t ) = (1 a)2 Var (pt1 ) + b2 Var (ut ) 2 (1 a) bCov (pt1 , ut )

(23)

Var (pt ) = a2 Var (pt1 ) + b2 Var (ut ) + 2abCov (pt1 , ut )

(24)

Cov (pt1 , ut ) = Cov (apt2 + but1 , ut1 + t )


= aCov (pt2 , ut1 ) + bVar (ut1 )
b
=
2
1 a u
23

(25)

Using that the price level is stationary and substituting (25) into (24) yields

2ab2 2

1 a2 Var (pt ) = b2 2u +
1 a u
b2 (1 + a)
Var (pt ) =
2u
2
(1 a ) (1 a)

Using (26) and (25) in (23) gives

(1 a2 ) b2 (1 + a)
2 (1 a) b2 2
2
Var ( t ) =
+b
u
(1 a2 ) (1 a)
1 a

1 a 1 + a 1 a
=
+
2 b2 2u
1 a 1 + a
1a
2 (1 )
=
b2 2u
(1 a) (1 + a)

(26)

(27)

To calculate the variance of the output-gap, it is convenient to use the form (22) and
note that this implies
Var (xt ) = c2 Var (pt1 ) + d2 Var (ut ) + 2cdCov (pt1 , ut )
Substituting (26) and (25) into the above equation gives
b2 (1 + a)
b
2
2 2

+
d

+
2cd
2u
u
u
2
(1 a ) (1 a)
1 a
2 2
2
2
b c (1 + a) + d (1 a ) (1 a) + 2bcd (1 a2 ) 2
=
u
(1 a2 ) (1 a)

Var (xt ) = c2

(28)

Inflation targeting, commitment

Following Currie and Levine [3], Woodford [16] and the appendix in Clarida, Gali and
Gertler [2], define the Lagrangian
)
(
X i

min Et
2t + x2t + t+i ( t+i xt+i t+i+1 ut+i )
{xi }
2
i=t
i=0
We start by taking the first order conditions with respect to inflation:

= i1 t+i1 + i t+i + t+i = 0


t+i
t+i = t+i1 t+i , i > 0
t = t (that is, i = 0)
24

(29)

Next, we take the first order conditions with respect to xt+i .

= xt+i t+i = 0
xt+i

t+i =
xt+i , i 0

(30)

Combining the first order conditions by substituting (30) into (29) gives

t+i = (xt+i xt+i1 )

(31)

Substituting (31) into the constraint finally gives a second order stochastic dierence
equation for xt :


(xt xt1 ) = xt
xt+1|t xt + ut

a
xt = axt1 + axt+1|t ut

with a =

.
(1+)+2

Rewrite the last equation as


xt+1|t

1
1

xt + xt1 =
ut
a

Factorizing the right hand side lead polynomial by solving


h2

1
1
h+ =0
a

Denoting the stable root by , we have


=
and, since h1 h2 =

1 4a2
2

we have the unstable root h2 =

1
.

Thus, we can rewrite our equation

as

(1 L) 1 L xt+1 =
ut

Solving this finally gives

1
ut
1

= xt1
ut
(1 )

(1 L) xt =
xt

25

(32)

By substituting (32) into (31), inflation can be recovered as


t = t1 +

(ut ut1 )
1

Or, summarizing the maximized policy in terms of the price level as


pt = a pt1 + b ut

b =

a =

(33)

a
1 a

( (1 + ) + )

1 4

(1+)+2

(34)

Inflation targeting, discretion

Since there is no credible promise can be made, and there is no endogenous state variable,
the value function in the case of inflation targeting can be written as

1 2
2
V (ut ) = Et min t + xt + V (ut+1 )
xt 2

= 0 + 1 ut + 2 u2t
2
where the minimization is subject to (1). The control variable xt will be a linear function
of the exogenous variables.
t
xt = du

(35)

Also, the forward looking variable (being a linear function of the exogenous variable and
the control variable) will have the form
t = but

(36)

t = xt + ut + Et ut+1

= xt + 1 + b ut

(37)

Using the above in () gives

26

Solving the minimization problem results in the following first order condition:

t
0 = Et t
+ xt
xt
= t + xt
or,

xt = t

(38)

Substituting (38) into (37) gives


t
t

= t + 1 + b ut

1 + b
=
ut
+ 2

Comparing (36) and (39) it is clear that


b =

1 + b
+ 2

or, solving for b


b =

+ (1 )

Substituting this into the first order condition gives


t
xt = du
where
d =

.
+ (1 )

27

(39)

Price-level targeting, discretion

Value function:6

1 2
2
Vt (pt1 , ut ) = Et min
p + xt + Vt+1 (pt , ut+1 )
yt
2 t
1
= 0,t + 1,t pt1 + 2,t p2t1
2
1
+ 3,t pt1 ut + 4,t ut + 5,t u2t
2

(40)

ut = ut1 + t
where the minimization in the above problem is subject to (1). The guessed value function
will only be used when taking conditional expectations at t of the derivative with respect
to pt , that is:
Et

V (pt , ut+1 ) = 1,t+1 + 2,t pt+1 + 3,t+1 Et ut+1


pt

so without loss 0,t , 4,t and 5,t can be set to zero. Note that if there is no persistence in
the residual process ( = 0) 3,t can also be set to zero. Finally, 1,t will only concern a
drift in the price level. If x , and pt are all set to zero, 1,t will be of no interest and
can also be set to zero. It is possible to show that the inflation bias resulting from x > 0
can be eliminated with a price level target with a drift. Thus, the guess of loss function
can be written
1
Vt (pt1 , ut ) = 1,t pt1 + 2,t p2t1 + 3,t pt1 ut
2

(41)

The state variable will follow a linear path (the quadratic loss function ensures that
the policy instrument xt is a linear function of the state variables)
pt+1 = at+1 pt + bt+1 ut+1
pt+1|t = at+1 pt
6

(42)

In the optimization, there is no dierence in considering the price level or the output-gap as the

control variable, since it is just two ways of substituting equation (??) into the loss function. However,
for consistency and as a preparation for future extensions when this property will not hold, the outputgap will be considered as the control variable and all derivatives of the output-gap with respect to the
price level will be replaced by the derivative of the price level with respect to the output-gap.

28

where the coecients are left to determine.


Rewrite (1) using t = pt pt1 :
xt =

1
(1 + ) pt pt+1|t (pt1 + ut )

Inserting (42) into the above equation gives


1
1
1 + bt+1
[1 + (1 at+1 )] pt pt1
ut

(43)

1
1 + bt+1
xt +
pt1 +
ut
1 + (1 at+1 )
1 + (1 at+1 )
1 + (1 at+1 )

(44)

xt =
or,
pt =

pt

=
xt
1 + (1 at+1 )
Vt+1 (pt , ut+1 )
= 2,t+1 pt + 3,t+1 ut+1
pt
Solving the minimization (40) results in the following first order conditions:

Vt+1 (pt , ut+1 ) pt


pt
0 = Et pt
+ xt +
xt
pt
xt

Vt+1 (pt , ut+1 ) pt

= Et
pt + xt +
1 + (1 at+1 )
pt
xt
[1 + (1 at+1 )]
xt + 2,t+1 pt + 3,t+1 Et ut+1
= pt +

>From (2) follows that Et (ut+1 ) = ut . Inserting this and (43) into the above and
simplifying gives
pt =

(1 + (1 at+1 ))
pt1 +
2 + (1 + (1 at+1 ))2 + 2 2,t+1
(1 + (1 at+1 )) (1 + bt+1 ) 2 3,t+1
2 + (1 + (1 at+1 ))2 + 2 2,t+1

ut

(45)

In order to solve the above equation, 2,t+1 and 3,t+1 must be identified. This can be
done by dierentiating (41) with respect to
Vp,t (pt1 , ut ) = 2,t pt + 3,t ut

29

(46)

and comparing this to the equivalent expression obtained using the envelope theorem on
(40)
Vp,t (pt1, ut ) =
=
=
=

1
Et xt

Et 2 {[1 + (1 at+1 )] pt pt1 (1 + bt+1 ) ut }

2 {[1 + (1 at+1 )] (bt ut + at pt1 ) pt1 (1 + bt+1 ) ut }

(1 [1 + (1 at+1 )] at ) pt1 +
(47)
2

{(1 + bt+1 ) [1 + (1 at+1 )] bt } ut


(48)
2

comparing (46) and (47) it is clear that

{1 [1 + (1 at+1 )] at }
2

(49)

{(1 + bt+1 ) [1 + (1 at+1 )] bt }


2

(50)

2,t =

3,t =

Using (49) and (50) in (45) gives


pt =

[1 + (1 at+1 )]
pt1 +
+ [1 + (1 at+1 )]2 + {1 [1 + (1 at+2 )] at+1 }
[1 + (1 at+1 )] + {bt+1 (1 + bt+2 ) + [1 + (1 at+2 )] bt+1 }
ut
2 + [1 + (1 at+1 )]2 + {1 [1 + (1 at+2 )] at+1 }
2

Finally, comparing this to (42), the following equations must hold:


at =

bt =

[1 + (1 at+1 )]
+ [1 + (1 at+1 )]2 + {1 [1 + (1 at+2 )] at+1 }

[1 + (1 at+1 )] + {bt+1 (1 + bt+2 ) + [1 + (1 at+2 )] bt+1 }


2 + [1 + (1 at+1 )]2 + {1 [1 + (1 at+2 )] at+1 }

30

(51)

(52)

F
F.1

Limit calculations
Inflation targeting, commitment

We have

lim a () =

2
s

( (1 + ) + 2 ) 1

lim

lim

(1 + ) +

(1 + ) 1

1 4

1 4

1 4

1
(1+)

(1+)+2

1
2
(1+)+

(1+)+2

= 1.
Next, the lower limit

lim a () = lim

( (1 + ) + 2 ) 1

= lim

= lim

e0

1 4

1 4

2
2

(1+)+2

2
(1+)+2

p
1 4e2

, with e =
2e
(1 + ) + 2
12

(1 4e2 )
= lim
e0
2
= 0

(8e)

where we have used LHospitals rule.

F.2

Price-level targeting, discretion


= lim
lim a

+
(1 a)

0
0
2 + 2

= 0
lim a

31

+
(1 a)

2 + 2

lim a = lim 2
2

a)
+ + (1


lim a =

2 + 1 lim
a

lim a =

lim

>From the last line we see that lim


a
= 1 is a solution (remember that = 1 +

(1 a
) .

The loss function

This appendix deals with explaining how the loss function can be rewritten in terms of
variances. This section formalizes the argument in Rudebusch and Svensson ([11]). The
loss function is given by
(1 )

i Lt+i .

i=0

The central bank is minimizing this conditional upon the information available at time t.
However, we are interested in how the policy preforms on average. This is represented by
taking the unconditional expected value of the loss function. That is
"
#

X
X
i Lt+i = (1 )
i E [Lt+i ]
E (1 )
i=0

i=0

= E [Lt ]

The central bank is minimizing


"
Et (1 )

X
i=0

Lt+i . = (1 )

i Et [Lt+i ]

i=0

In the case of discretion and no exogenous persistence, it is not possible to aect the
conditional expected future value. Thus, Lt is a constant, and all future terms are equal

32

to the unconditional expected value of Lt+i . This gives


= (1 ) Lt + (1 )

i E [Lt+i ]

i=1

= (1 ) (Lt E (Lt )) + (1 )
= (1 ) (Lt E (Lt )) + (1 )
= (1 ) (Lt E (Lt )) + E (Lt )

i E [Lt ]

i=0

E (Lt )
1

In the limit when 1, the first term disappears.


In the case of commitment (and/or residual persistence), the story is slightly more
complicated. Then, it is possible to aect future expected values of the loss function
today. However, in the limit when 1, we get the same result. This is because when
i becomes big enough, the expected level of the variables in the loss function will return
to their steady state values. Thus, the conditional expected value will converge towards
the unconditional expected value. Given that 1, the weight of the values in the
beginning of the sum, that are out of steady state, will eventually be dominated by the
vast number of terms that has converged into the steady state.

33