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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.

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 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

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.

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

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)

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)

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)

+ (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)

Var (t ) = b2 2u

(15)

Var (xt ) = d2 2u

(16)

with

2u =

3.3

1

2

1 2

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)

(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

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

ITD

1

0.8

ITC

PTD

0.6

0.4

0.2

0.5

1.5

2.5

Figure 1:

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

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

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

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

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

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)

t = (1 a) pt1 + but

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

(23)

(24)

= 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)

(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)

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:

t+i

t+i = t+i1 t+i , i > 0

t = t (that is, i = 0)

24

(29)

= 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

(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

xt+1|t

1

1

xt + xt1 =

ut

a

h2

1

1

h+ =0

a

=

and, since h1 h2 =

1 4a2

2

1

.

as

(1 L) 1 L xt+1 =

ut

1

ut

1

= xt1

ut

(1 )

(1 L) xt =

xt

25

(32)

t = t1 +

(ut ut1 )

1

pt = a pt1 + b ut

b =

a =

(33)

a

1 a

( (1 + ) + )

1 4

(1+)+2

(34)

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)

26

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

t

0 = Et t

+ xt

xt

= t + xt

or,

xt = t

(38)

t

t

= t + 1 + b ut

1 + b

=

ut

+ 2

b =

1 + b

+ 2

b =

+ (1 )

t

xt = du

where

d =

.

+ (1 )

27

(39)

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

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

Rewrite (1) using t = pt pt1 :

xt =

1

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

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:

pt

0 = Et pt

+ xt +

xt

pt

xt

= 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

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

(47)

2

(48)

2

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

2

(49)

2

(50)

2,t =

3,t =

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

at =

bt =

[1 + (1 at+1 )]

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

F.2

= 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

a

= 1 is a solution (remember that = 1 +

(1 a

) .

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 ]

"

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

= (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 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

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