JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content. The resurgence of interest in the issue of h ow to conduct monetary policy is symptomatic of th e enormous volume of recent w orking papers and conferences on the topic.
JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content. The resurgence of interest in the issue of h ow to conduct monetary policy is symptomatic of th e enormous volume of recent w orking papers and conferences on the topic.
JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content. The resurgence of interest in the issue of h ow to conduct monetary policy is symptomatic of th e enormous volume of recent w orking papers and conferences on the topic.
The Science of Monetary Policy: A New Keynesian Perspective
Author(s): Richard Clarida, Jordi Gal and Mark Gertler Source: Journal of Economic Literature, Vol. 37, No. 4 (Dec., 1999), pp. 1661-1707 Published by: American Economic Association Stable URL: http://www.jstor.org/stable/2565488 . Accessed: 05/06/2014 02:59 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp . JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. . American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to Journal of Economic Literature. http://www.jstor.org This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions Journal of Economic Literature Vol. XXXVII (December 1999), pp. 1661-1 707 T h e S cience of Monetary P olicy: A N ew Keynesian P erspective Rich ard Clarida, Jordi Gall, and Mark Gertlerl "Having looked at monetary policy from both sides now , I can testify th at central banking in practice is as much art as science. N oneth eless, w h ile practicing th is dark art, I h ave alw ays found th e science quite useful."2 A lan S . Blinder 1. Introduction T HERE HA S BEEN a great resurgence of interest in th e issue of h ow to con- duct monetary policy. One symptom of th is ph enomenon is th e enormous vol- ume of recent w orking papers and con- ferences on th e topic. A noth er is th at over th e past several years many leading macroeconomists h ave eith er proposed specific policy rules or h ave at least staked out a position on w h at th e general course of monetary policy sh ould be. Joh n T aylor's recommendation of a sim- ple interest rate rule (T aylor 1993a) is a w ell-know n example. S o too is th e recent w idespread endorsement of inflation tar- geting (e.g., Ben Bernanke and Frederic Mish kin 1997). T w o main factors underlie th is re- birth of interest. First, after a long pe- riod of near exclusive focus on th e role of nonmonetary factors in th e business cycle, a stream of empirical w ork begin- ning in th e late 1980s h as made th e case th at monetary policy significantly influ- ences th e sh ort-term course of th e real economy.3 T h e precise amount remains open to debate. On th e oth er h and, th ere now seems to be broad agreement th at th e ch oice of h ow to conduct monetary policy h as important conse- quences for aggregate activity. It is no longer an issue to dow nplay. S econd, th ere h as been considerable improvement in th e underlying th eoret- ical framew orks used for policy analysis. T o provide th eoretical underpinnings, th e literature h as incorporated th e tech - niques of dynamic general equilibrium th eory pioneered in real business cycle 1 Clarida: Columbia University and N BER; Galf: N ew York University, Universitat P ompeu Fabra, CEP R, and N BER; Gertler: N ew York University and N BER. T h anks to Ben Bernanke, Bob King, Ben McCallum, A lbert Marcet, Rick Mish kin, A th anasios Orph anides, Glenn Rudebusch , Ch ris S ims, Lars S vensson, A ndres Velasco, and several anonymous referees for h elpful comments, and to T ommaso Monacelli for excellent research assis- tance. A uth ors Galf and Gertler are grateful to th e C.V. S tarr Center for A pplied Economics, and (Galf) to CREI for financial support. e-mail: mark.gertler@econ.nyu.edu 2 Blinder 1997, p. 17. 3 Examples include Romer and Romer (1988), Bernanke and Blinder (1992), Galf (1992), Ber- nanke and Mih ov (1997a), Ch ristiano, Eich en- baum, and Evans (1996, 1998) and Leeper, S ims and Zh a (1996). Much of th e literature h as fo- cused on th e effects of monetary policy sh ocks. Bernanke, Gertler, and Watson (1997) present evi- dence th at suggests th at th e monetary policy rule may h ave important effects on real activity. 1661 This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions 1662 Journal of Economic Literature, Vol. XXXVII (December 1999) analysis. A key point of departure from real business cycle th eory (as w e later make clear) is th e explicit incorporation of frictions such as nominal price rigidi- ties th at are needed to make th e frame- w ork suitable for evaluation of monetary policy. T h is paper summarizes w h at w e h ave learned from th is recent research on monetary policy. We review th e prog- ress th at h as been made and also iden- tify th e central questions th at remain. T o organize th e discussion, w e exposit th e monetary policy design problem in a simple th eoretical model. We start w ith a stripped-dow n baseline model in or- der to ch aracterize a number of broad principles th at underlie optimal policy management. We th en consider th e im- plications of adding various real w orld complications. Finally, w e assess h ow th e predictions from th eory square w ith policy-making in practice. T h rough out, w e concentrate on ex- positing results th at are robust across a w ide variety of macroeconomic frame- w orks. A s Ben McCallum (1997b) em- ph asizes, th e key stumbling block for policy formation is limited know ledge of th e w ay th e macroeconomy w orks. Results th at are h igh ly model-specific are of limited use. T h is literature, h ow - ever, contains a number of useful prin- ciples about optimal policy th at are rea- sonably general in applicability. In th is respect th ere is a "science of monetary policy," as A lan Blinder suggests in th e quote above. We provide support for th is contention in th e pages th at follow . A t th e same time, w e sh ould make clear th at th e approach w e take is based on th e idea th at temporary nominal price rigidities provide th e key friction th at gives rise to nonneutral effects of monetary policy. T h e propositions w e derive are broadly applicable w ith in th is class of models. T h is approach h as w idespread support in both th eoretical and applied w ork, as w e discuss later.4 T h ere are, h ow ever, important strands of th e literature th at eith er reject th e idea of nominal price rigidities (e.g., real business cycle th eory) or focus on oth er types of nominal rigidities, such as frictions in money demand.5 For th is reason, w e append "N ew Keynesian P erspective" to th e title. In particular, w e w ish to make clear th at w e adopt th e Keynesian approach of stressing nomi- nal price rigidities, but at th e same time base our analysis on framew orks th at in- corporate th e recent meth odological ad- vances in macroeconomic modeling (h ence th e term "N ew "). S ection 2 lays out th e formal policy problem. We describe th e baseline th eoretical model and th e objectives of policy. Because w e are interested in ch aracterizing policy rules in terms of primitive factors, th e model w e use evolves from first principles. T h ough it is quite simple, it noneth eless contains th e main ingredients of descriptively rich er framew orks th at are used for pol- icy analysis. With in th e model, as in practice (w e argue), th e instrument of monetary policy is a sh ort-term interest rate. T h e policy design problem th en is to ch aracterize h ow th e interest rate sh ould adjust to th e current state of th e economy. A n important complication is th at pri- vate sector beh avior depends on th e ex- pected course of monetary policy, as w ell as on current policy. T h e credibil- ity of monetary policy th us becomes relevant, as a considerable contemporary literature h as emph asized.6 A t issue is 4S ee, for example, th e survey by Goodfriend and King (1997). 5 S ee, for example, Ch ristiano, Eich enbaum, and Evans (1997). For an analysis of monetary pol- icy rules in th ese kinds of models-know n as 'lim- ited participation" framew orks-see Ch ristiano and Gust (1999). 6For a recent survey of th e credibility litera- ture, see P ersson and T abellini (1997). This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions Clarida, Gall, Gertler: T h e S cience of Monetary P olicy 1663 w h eth er th ere may be gains from en- h ancing credibility eith er by formal commitment to a policy rule or by intro- ducing some kind of institutional ar- rangement th at ach ieves rough ly th e same end. We address th e issue by ex- amining optimal policy for both cases: w ith and w ith out commitment. A long w ith expositing traditional results, w e also exposit some new results regarding th e gains from commitment. S ection 3 derives th e optimal policy rule in th e absence of commitment. If for no oth er reason, th is case is of inter- est because it captures reality: N o ma- jor central bank makes any type of bind- ing commitment over th e future course of its monetary policy. A number of broad implications emerge from th is baseline case. A mong th ese: T h e opti- mal policy embeds inflation targeting in th e sense th at it calls for gradual adjust- ment to th e optimal inflation rate. T h e implication for th e policy rule is th at th e central bank sh ould adjust th e nominal sh ort rate more th an one-for- one w ith expected future inflation. T h at is, it sh ould adjust th e nominal rate suf- ficiently to alter th e real rate (and th us aggregate demand) in th e direction th at is offsetting to any movement in ex- pected inflation. Finally, h ow th e cen- tral bank sh ould adjust th e interest rate in response to output disturbances de- pends critically on th e nature of th e dis- turbances: It sh ould offset demand sh ocks but accommodate supply sh ocks, as w e discuss. S ection 4 turns to th e case w ith com- mitment. Much of th e literature h as emph asized th at an inefficiently h igh steady state inflation rate may arise in th e absence of commitment, if th e cen- tral bank's target for real output ex- ceeds th e market clearing level.7 T h e gain from commitment th en is to elimi- nate th is inflationary bias. How realistic it is to presume th at a perceptive cen- tral bank w ill try to inadvisedly reap sh ort-term gains from push ing output above its natural level is a matter of re- cent controversy (e.g., Blinder 1997; McCallum 1997a). We demonstrate, h ow ever, th at th ere may be gains from commitment simply if current price set- ting depends on expectations of th e fu- ture. In th is instance, a credible com- mitment to figh t inflation in th e future can improve th e current output/infla- tion trade-off th at a central bank faces. S pecifically, it can reduce th e effective cost in terms of current output loss th at is required to low er current inflatibn. T h is result, w e believe, is new in th e literature. In practice, h ow ever, a binding com- mitment to a rule may not be feasible simply because not enough is know n about th e structure of th e economy or th e disturbances th at buffet it. Under certain circumstances, h ow ever, a pol- icy rule th at yields w elfare gains rela- tive to th e optimum under discretion may be w ell approximated by an opti- mal policy under discretion th at is ob- tained by assigning a h igh er relative cost to inflation th an th e true social cost. A w ay to pursue th is policy opera- tionally is simply to appoint a central bank ch air w ith a greater distaste for infla- tion th an society as a w h ole, as Kenneth Rogoff (1985) originally emph asized. S ection 5 considers a number of prac- tical problems th at complicate policy- making. T h ese include: imperfect infor- mation and lags, model uncertainty and non-smooth preferences over inflation and output. A number of pragmatic is- sues emerge, such as: w h eth er and h ow to make use of intermediate targets, th e ch oice of a monetary policy instrument, and w h y central banks appear to smooth interest rate ch anges. A mong oth er 7 T h e potential. inflationary bias under discre- tion w as originally emph asized by Kydland and P rescott (1977) and Barro and Gordon (1983). This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions 1664 Journal of Economic Literature, Vol. XXXVII (December 1999) th ings, th e analysis makes clear w h y modern central banks (especially th e Federal Reserve Board) h ave greatly dow ngraded th e role of monetary aggre- gates in th e implementation of policy. T h e section also sh ow s h ow th e recently advocated "opportunistic" approach to figh ting inflation may emerge und-er a non-smooth policy objective function. T h e opportunistic approach boils dow n to trying to keep inflation from rising but allow ing it to ratch et dow n in th e event of favorable supply sh ocks. A s w e illustrate th rough out, th e opti- mal policy depends on th e degree of persistence in both inflation and out- put. T h e degree of inflation persistence is critical since th is factor governs th e output/inflation trade-off th at th e pol- icy-maker faces. In our baseline model, persistence in inflation and output is due entirely to serially correlated ex- ogenous sh ocks. In section 6 w e con- sider a h ybrid model th at allow s for en- dogenous persistence in both inflation and output. T h e model nests as special cases our forw ard-looking baseline model and, also, a more traditional backw ard-looking Keynesian frame- w ork, similar to th e one used by Lars S vensson (1997a) and oth ers. S ection 7 moves from th eory to prac- tice by considering a number of pro-' posed simple rules for monetary policy, including th e T aylor rule, and a forw ard- looking variant considered by Clarida, Galf, and Gertler (1998; forth coming). A ttention h as centered around simple rules because of th e need for robust- ness. A policy rule is robust if it pro- duces desirable results in a variety of competing macroeconomic framew orks. T h is is tantamount to h aving th e rule satisfy th e criteria for good policy man- agement th at sections 2 th rough 6 es- tablish . Furth er, U.S . monetary policy may be judged according to th is same met- ric. In particular, th e evidence suggests th at U.S . monetary policy in th e fifteen years or so prior to P aul Volcker did not alw ays follow th e principles w e h ave de- scribed. S imply put, interest rate man- agement during th is era tended to ac- commodate inflation. Under Volcker and Greenspan, h ow ever, U.S . mone- tary policy adopted th e kind of implicit inflation targeting th at w e argue is consistent w ith good policy management. T h e section also considers some pol- icy proposals th at focus on target vari- ables, including introducing formal inflation or price-level targets and nominal GDP targeting. T h ere is in ad- dition a brief discussion of th e issue of w h eth er indeterminacy may cause prac- tical problems for th e implementation of simple interest rate rules. Finally, th ere are concluding remarks in section 8. 2. A Baseline Framew ork for A nalysis of Monetary P olicy T h is section ch aracterizes th e formal monetary policy design problem. It first presents a simple baseline macro- economic framew ork, and th en de- scribes th e policy objective function. T h e issue of credibility is taken up next. In th is regard, w e describe th e distinc- tion betw een optimal policies w ith and w ith out credible commitment-w h at th e literature refers to as th e cases of "rules versus discretion." 2.1 A S imple Macroeconomic Framew ork Our baseline framew ork is a dynamic general equilibrium model w ith money and temporary nominal price rigidities. In recent years th is paradigm h as be- come w idely used for th eoretical analy- sis of monetary policy.8 It h as much of th e empirical appeal of th e traditional 8 S ee, e.g, Goodfriend and King (1997), McCal- lum and N elson (1997), Walsh (1998), and th e ref- erences th erein. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions Clarida, Gall, Gertler: T h e S cience of Monetary P olicy 1665 IS /LM model, yet is grounded in dy- namic general equilibrium th eory, in keeping w ith th e meth odological ad- vances in modern macroeconomics. With in th e model, monetary policy affects th e real economy in th e sh ort run, much as in th e traditional Keynes- ian IS /LM framew ork. A key difference, h ow ever, is th at th e aggregate beh av- ioral equations evolve explicitly from optimization by h ouseh olds and firms. One important implication is th at cur- rent economic beh avior depends criti- cally on expectations of th e future course of monetary policy, as w ell as on current policy. In addition, th e model accommodates differing view s about h ow th e macroeconomy beh aves. In th e limiting case of perfect price flexibility, for example, th e cyclical dynamics re- semble th ose of a real business cycle model, w ith monetary policy affecting only nominal variables. Rath er th an w ork th rough th e details of th e derivation, w h ich are readily available elsew h ere, w e instead directly introduce th e key aggregate relation- sh ips.9 For convenience, w e abstract from investment and capital accumula- tion. T h is abstraction, h ow ever, does not affect any qualitative conclusions, as w e discuss. T h e model is as follow s: Let yt and Zt be th e stoch astic compo- nents of output and th e natural level of output, respectively, both in logs.10 T h e latter is th e level of output th at w ould arise if w ages and prices w ere perfectly flexible. T h e difference betw een actual and potential output is an important vari- able in th e model. It is th us convenient to define th e "output gap" xt: Xt t - Zt In addition, let tt be th e period t infla- tion rate, defined as th e percent ch ange in th e price level from t-I to t; and let it be th e nominal interest rate. Each vari- able is similarly expressed as a deviation from its long-run level. It is th en possible to represent th e baseline model in terms of tw o equa- tions: an "IS " curve th at relates th e out- put gap inversely to th e real interest rate; and a P h illips curve th at relates inflation positively to th e output gap. Xt = - p[it - Et2tt+ l] + Etxt+ 1 + gt (2.1) tt = Xxt + Et2t + i + ut (2.2) w h ere gt and ut are disturbances terms th at obey, respectively: gt=R9gt-1+gt (2.3) A Ut=put-i+ut (2.4) w h ere 0 < g,p < 1 and w h ere both A t and A ut are i.i.d. random variables w iti zero mean and variances ay and 2, respectively. Equation (2.1) is obtained by log- linearizing th e consumption euler equa- tion th at arises from th e h ouseh old's optimal saving decision, after imposing th e equilibrium condition th at con- sumption equals output minus govern- ment spending.11 T h e resulting expres- sion differs from th e traditional IS curve mainly because current output depends on expected future output as w ell as th e interest rate. High er ex- pected future output raises current out- put: Because individuals prefer to 9 S ee, for example, Yun (1996), Kimball (1995), King and Wolman (1995), Woodford (1996), and Bernanke, Gertler, and Gilch rist (1998) for step- by-step derivations. 10 By stoch astic component, w e mean th e devia- tion from a deterministic long-run trend. 11 Using th e market clearing condition Yt = Ct + Et, w h ere Et is government consumption, w e can re- w rite th e log-linearized consumption Euler equa- tion as: yt - et= - (p[it - Ett + 1 + Et{yt + 1 - et + 11 w h ere et - log(l - j-) is taken to evolve ex- ogenously. Using x- Yt - zt, it is th en possible to derive th e demand for output as Xt = - p[it - Etzt+ 1] + Etxt + I + gt w h ere gt = Et{A zt + 1 - A et + 1. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions 1666 Journal of Economic Literature, Vol. XXXVII (Decenmber 1999) smooth consumption, expectation of h igh er consumption next period (associ- ated w ith h igh er expected output) leads th em to w ant to consume more today, w h ich raises current output demand. T h e negative effect of th e real rate on current output, in turn, reflects in- tertemporal substitution of consump- tion. In th is respect, th e interest elastic- ity in th e IS curve, (p, corresponds to th e intertemporal elasticity of substitu- tion. T h e disturbance gt is a function of expected ch anges in government pur- ch ases relative to expected ch anges in potential output (see footnote 11). S ince gt sh ifts th e IS curve, it is inter- pretable as a demand sh ock. Finally, add- ing investment and capital to th e model ch anges th e details of equation (2.1). But it does not ch ange th e fundamental qualitative aspects: output demand still depends inversely on th e real rate and positively on expected future output. It is instructive to iterate equation (2.1) forw ard to obtain 00 xt=EtX { - p[it+i-nt+1+i] +gt+i} (2.5) i=O Equation (2.5) makes transparent th e degree to w h ich beliefs about th e future affect current aggregate activity w ith in th is framew ork. T h e output gap de- pends not only on th e current real rate and th e demand sh ock, but also on th e expected future path s of th ese tw o variables. T o th e extent monetary policy h as leverage over th e sh ort-term real rate due to nominal rigidities, equation (2.5) suggests th at expected as w ell as current policy actions affect aggregate demand. T h e P h illips curve, (2.2), evolves from staggered nominal price setting, in th e spirit of S tanley Fisch er (1977) and Joh n T aylor (1980).12 A key difference is th at th e individual firm price-setting decision, w h ich provides th e basis for th e aggregate relation, is derived from an explicit optimization problem. T h e starting point is an environment w ith monopolistically competitive firms: Wh en it h as th e opportunity, each firm ch ooses its nominal price to maximize profits subject to constraints on th e frequency of future price adjustments. Under th e standard scenario, each pe- riod th e fraction 1/X of firms set prices for X > 1 periods. In general, h ow ever, aggregating th e decision rules of firms th at are setting prices on a staggered basis is cumbersome. For th is reason, underlying th e specific derivation of equation (2.2) is an assumption due to Guillermo Calvo (1983) th at greatly simplifies th e problem: In any given pe- riod a firm h as a fixed probability 0 it must keep its price fixed during th at pe- riod and, h ence a probability 1 - 0 th at it may adjust. 13 T h is probability, fur- th er, is independent of th e time th at h as elapsed since th e last time th e firm ch anged price. A ccordingly, th e average time over w h ich a price is fixed is T h us, for example, if 0 = .75, prices are fixed on average for a year. T h e Calvo formulation th us captures th e spirit of staggered setting, but facilitates th e ag- gregation by making th e timing of a firm's price adjustment indepeiident of its h istory. Equation (2.2) is simply a loglinear approximation about th e steady state of th e aggregation of th e individual firm pricing decisions. S ince th e equation re- lates th e inflation rate to th e output gap and expected inflation, it h as th e flavor of a traditional expectations-augmented P h illips curve (see, e.g., Olivier Blanch ard 12 S ee Galf and Gertler (1998) and S bordone (1998) for some empirical support for th is kind of P h illips curve relation. 13 T h e Calvo formulation h as become quite common in th e literature. Work by Yun (1996), King and Wolman (1995), Woodford (1996) and oth ers h as initiated th e revival. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions Clarida, Gall', Gertler: T h e S cience of Monetary P olicy 1667 1997). A key difference w ith th e stan- dard P h illips curve is th at expected fu- ture inflation, Etnt+j, enters additively, as opposed to expected current infla- tion, Et - itt.14 T h e implications of th is distinction are critical: T o see, iterate (2.2) forw ard to obtain 00 7it = Etl: P ~,Vit + i + Itt + i] (2.6) i=O In contrast to th e traditional P h illips curve, th ere is no arbitrary inertia or lagged dependence in inflation. Rath er, inflation depends entirely on current and expected future economic condi- tions. Rough ly speaking, firms set nomi- nal price based on th e expectations of future marginal costs. T h e variable xt+i captures movements in marginal costs associated w ith variation in excess de- mand. T h e sh ock ut + i, w h ich w e refer to as "cost push ," captures anyth ing else th at migh t affect expected marginal costs.15 We allow for th e cost push sh ock to en- able th e model to generate variation in inflation th at arises independently of movement in excess demand, as appears present in th e data (see, e.g., Fuh rer and Moore 1995). T o close th e model, w e take th e nominal interest rate as th e instrument of monetary policy, as opposed to a money supply aggregate. A s Bernanke and Ilian Mih ov (1998) sh ow , th is as- sumption provides a reasonable descrip- tion of Federal Reserve operating pro- cedures since 1965, except for th e brief period of non-borrow ed reserves target- ing (1980-82) under P aul Volcker.16 With th e nominal rate as th e policy in- strument, it is not necessary to specify a money market equilibrium condition (i.e., an LM curve).17 In section 5, w e discuss th e implications of using instead a narrow monetary aggregate as th e policy instrument. T h ough simple, th e model h as th e same qualitative core features as more 14 A noth er key difference is th at th e explicit derivation restricts th e coefficient X on th e output gap. In particular, X is decreasing in 0, w h ich mea- sures th e degree of price rigidity. T h us, th e longer prices are fixed on average, th e less sensitive is inflation to movements in th e output gap. 15T h e relation for inflation th at evolves from th e Calvo model takes th e form jut = Et{t + 1} + 6 mct w h ere mct denotes th e deviation of (real) marginal cost from its steady state value. T o th en relate in- flation to th e output gap, th e literature typically makes assumptions on tech nology, preferences, and th e structure of labor markets to justify a pro- portionate relation betw een real marginal cost and th e output gap, so th at mct = K xt h olds, w h ere K is th e output elasticity of real marginal cost. In th is instance, one can rew rite th e relation for inflation in terms of th e output gap, as follow s: zt = P Etfnt + 1} + X xt (see Galf and Gertler (1998) for details). In th is context, th e disturbance Ut in (2.2) is interpretable as reflecting deviations from th e condition rnct = K Xt. (Indeed th e evidence in Galf and Gertler 1998 suggests th at mct does not vary proportionately w ith xt). Deviations from th is proportionality condition could be caused, for ex- ample, by movements in nominal w ages th at push real w ages aw ay from th eir "equilibrium" values due to frictions in th e w age contracting process. On th is latter point, see Erceg, Henderson, and Levin (1998). A noth er interpretation of th e ut sh ock (suggested by Mike Woodford) is th at it could re- flect a sh ock to th e gap betw een th e natural and potential levels of output (e.g., a markup sh ock). 16 Rough ly speaking, Bernanke and Mih ov (1998) present formal evidence sh ow ing th at th e Federal Reserve intervenes in th e market for non- borrow ed bank reserves to support its ch oice for th e level of th e Federal Funds rate, th e overnigh t market for bank reserves. (Ch ristiano, Eich en- baum, and Evans 1998, th ough , take issue w ith th e identifying assumptions in th e Bernanke-Mih ov test). Informally, Federal Reserve policy actions in recent years routinely take th e form of announcing a target for th e Federal funds rate (see, e.g, Rude- busch 1995). P olicy discussions, furth er, focus on w h eth er to adjust th at target, and by h ow much . In th is context, th e view th at th e Funds rate is th e policy instrument is w idely h eld by both practitio- ners of monetary policy and academic research ers (see, e.g., Goodfriend 1991, T aylor 1993, and Walsh 1998). 17With th e interest rate as th e policy instru- ment, th e central bank adjusts th e money supply to h it th e interest rate target. In th is instance, th e condition th at money demand equal money supply sinply determines th e value of th e money supply th at meets th is criteria. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions 1668 Journal of Economic Literature, Vol. XXXVII (December 1999) complex, empirically based framew orks th at are used for policy analysis.18 A s in th ese applied framew orks, temporary nominal price rigidities play a critical role. With nominal rigidities present, by varying th e nominal rate, monetary pol- icy can effectively ch ange th e sh ort- term real rate. T h rough th is classic mech anism it gains leverage over th e near term course of th e real economy. In contrast to th e traditional mech a- nism, th ough , beliefs about h ow th e central bank w ill set th e interest rate in th e future also matter, since both h ouseh olds and firms are forw ard look- ing. In th is kind of environment, h ow monetary policy sh ould respond in th e sh ort run to disturbances th at buffet th e economy is a nontrivial decision. Re- solving th is issue is th e essence of th e contemporary debate over monetary policy. 2.2 T h e P olicy Objective T h e central bank objective function translates th e beh avior of th e target variables into a w elfare measure to guide th e policy ch oice. We assume, follow ing much of th e literature, th at th is objective function is over th e tar- get variables xt and it, and takes th e form: max- 2 EtjEpt1Xt+i - -Ejt2+,] (2.7) 2 f w h ere th e parameter oc is th e relative w eigh t on output deviations. S ince Xt --yt - zt, th e loss function takes poten- tial output Zt as th e target. It also implic- itly takes zero as th e target inflation, but th ere is no cost in terms of generality since inflation is expressed as a percent deviation from trend.19 Wh ile th ere h as been considerable progress in motivating beh avioral mac- roeconomic models from first princi- ples, until very recently, th e same h as not been true about rationalizing th e objectives of policy. Over th e past sev- eral years, th ere h ave been a number of attempts to be completely coh erent in formulating th e policy problem by taking as th e w elfare criterion th e util- ity of a representative agent w ith in th e model.20 One limitation of th is approach , h ow - ever, is th at th e models th at are cur- rently available do not seem to capture w h at many w ould argue is a major cost of inflation, th e uncertainty th at its vari- ability generates for lifetime financial planning and for business planning (see, e.g., Brad DeLong 1997).21 A noth er is- sue is th at, w h ile th e w idely used repre- sentative agent approach may be a rea- sonable w ay to motivate beh avioral relationsh ips, it could be h igh ly mis- leading as a guide to w elfare analysis. If some groups suffer more in recessions th an oth ers (e.g. steel w orkers versus professors) and th ere are incomplete in- surance and credit markets, th en th e utility of a h ypoth etical representative agent migh t not provide an accurate barometer of cyclical fluctuations in w elfare. With certain exceptions, much of th e 18 S ome prominent examples include th e re- cently renovated large scale model used by th e Federal Reserve Board, th e FRB-US model (see Brayton, Levin, T yron, and Williams 1997), and th e medium scale models of T aylor (1979, 1993b) and Fuh rer and Moore (1995a,b). 19 P ut differently, under th e optimal policy, th e target inflation rate pins dow n th e trend inflation rate. T h e loss function th us penalizes deviations from th is trend. 2.O S ome examples of th is approach include A iya- gari and Braun (1997), King and Wolman (1995), Ireland (1996a), Carlstrom and Fuerst (1995), and Rotemberg and Woodford (1997). 21 Underlying th is kind of cost is th e observation th at contracts are typically w ritten in nominal terms and, for reasons th at are difficult to explain, not perfectly indexed to th e price level. On th is issue, see th e discussion in S h iller (1997) and th e associated comment by Hall (1997). This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions Clarida, Galf, Gertler: T h e S cience of Monetary P olicy 1669 literature takes a pragmatic approach to th is issue by simply assuming th at th e objective of monetary policy is to mini- mize th e squared deviations of output and inflation from th eir respective tar- get levels. How ever, Julio Rotemberg and Mich ael Woodford (1999) and Woodford (1998) provide a formal justi- fication for th is approach . T h ese auth ors sh ow th at an objective function looking someth ing like equation (2.7) may be obtained as a quadratic approxi- mation of th e utility-based w elfare function. In th is instance, th e relative w eigh t, oc, is a function of th e primitive parameters of th e model. In w h at follow s, w e simply adopt th e quadratic objective given by (2.7), ap- pealing loosely to th e justification of- fered in Rotemberg and Woodford (1999). Judging by th e number of pa- pers w ritten by Federal Reserve econo- mists th at follow th is lead, th is formula- tion does not seem out of sync w ith th e w ay monetary policy operates in prac- tice (at least implicitly).22 T h e target level of output is typically taken to be th e natural level of output, based on th e idea th at th is is th e level of output th at w ould obtain absent any w age and price frictions. Yet, if distortions exist in th e economy (e.g., imperfect competition or taxes), a case can be made th at th e w elfare maximizing level of output may exceed its natural level. T h is issue be- comes important in th e context of policy credibility, but w e defer it for now . Wh at sh ould be th e target rate of in- flation is perh aps an even more eph em- eral question, as is th e issue of w h at sh ould be th e relative w eigh t assigned to output and inflation losses. In th e U.S ., policy-makers argue th at "price stability" sh ould be th e ultimate goal. But th ey define price stability as th e in- flation rate at w h ich inflation is no longer a public concern. In practice, it is argued th at an inflation rate betw een one and th ree percent seems to meet th is definition (e.g., Bernanke and Mish kin 1997). A furth er justification for th is criteria is th at th e official price indices may be overstating th e true in- flation rate by a percent or tw o, as ar- gued recently by th e Boskin Commis- sion. In th is regard, interestingly, th e Bundesbank h as h ad for a long time an official inflation target of tw o percent.23 T h ey similarly argue th at th is positive rate of inflation is consistent w ith price stability, and cite measurement error as one of th e reasons (Clarida and Gertler 1997). It is clear th at th e experience of th e 1970s aw akened policy-makers to th e costs of h igh inflation (DeLong 1997). Oth erw ise, th ere is no directly observ- able indicator of th e relative w eigh ts as- signed to output and inflation objec- tives. N or, argues Blinder (1997), is th ere any obvious consensus among pol- icy-makers about w h at th ese w eigh ts re- ally are in practice. It is true th at th ere h as been a grow ing consensus th at th e primary aim of monetary policy sh ould be to control inflation (see, e.g., Ber- nanke and Mish kin 1997). But th is dis- cussion in many respects is about w h at kind of policy rule may be best, as op- posed to w h at th e underlying w elfare function looks like. For our purposes, h ow ever, it is rea- sonable to take th e inflation target and preference parameters as given and simply explore th e implications for optimal policy rules. 22 S ee, for example, Williams (1997) and refer- ences th erein. 23T w o percent is also th e upper bound of th e inflation target range establish ed by th e European Central Bank. On th e oth er h and, Feldstein (1997) argues th at th e tax distortions th at arise because corporate and personal income taxes are not in- dexed to inflation justify moving from th ree per- cent to zero inflation. i This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions 1670 Journal of Economic Literature, Vol. XXXVII (December 1999) 2.3 T h e P olicy P roblem and Discretion versus Rules T h e policy problem is to ch oose a time path for th e instrument it to engi- neer time path s of th e target variables xt and nt th at maximize th e objective function (2.7), subject to th e constraints on beh avior implied by (2.1) and (2.2). T h is formulation is in many w ays in th e tradition of th e classic Jan T inbergen (1952)/Henri T h eil (1961) (T T ) targets and instruments problem. A s w ith T T , th e combination of quadratic loss and linear constraints yields a certainty equivalent decision rule for th e path of th e instrument. T h e optimal feedback rule, in general, relates th e instrument to th e state of th e economy. T h ere is, h ow ever, an important dif- ference from th e classic problem: T h e target variables depend not only on th e current policy but also on expectations about future policy: T h e output gap de- pends on th e future path of th e interest rate (equation 2.5); and, in turn, inflation depends on th e current and expected future beh avior of th e output gap (equation 2.6). A s Finn Kydland and Edw ard P rescott (1977) originally em- ph asized, in th is kind of environment, credibility of future policy intentions becomes a critical issue. For example, a central bank th at can credibly signal its intent to maintain inflation low in th e future may be able to reduce current inflation w ith less cost in terms of out- put reduction th an migh t oth erw ise be required.24 In section 4, w e illustrate th is point explicitly. From th e standpoint of policy design, th e issue is to identify w h eth er some type of credibility-enh ancing commit- ment may be desirable. A nsw ering th is question boils dow n to comparing opti- mal policy under discretion versus rules (using th e terminology of th e litera- ture). In our context, a central bank op- erating under discretion ch ooses th e current interest rate by reoptimizing every period. A ny promises made in th e past do not constrain current policy. Under a rule, it ch ooses a plan for th e path of th e interest rates th at it sticks to forever. T h e plan may call for adjusting th e interest rate in response to th e state of th e economy, but both th e nature and size of th e response are etch ed in stone. T w o points need to be emph asized. First, th e key distinction betw een dis- cretion and rules is w h eth er current commitments constrain th e future course of policy in any credible w ay. In each instance, th e optimal outcome is a feedback policy th at relates th e policy instrument to th e current state of th e economy in a very specific w ay. T h e tw o approach es differ, h ow ever, in th eir im- plications for th e link betw een policy intentions and private sector beliefs. Under discretion, a perceptive private sector forms its expectations taking into account h ow th e central bank adjusts policy, given th at th e central bank is free to reoptimize every period. T h e ra- tional expectations equilibrium th us h as th e property th at th e central bank h as no incentive to ch ange its plans in an unexpected w ay, even th ough it h as th e discretion to do so. (For th is reason, th e policy th at emerges in equilibrium under discretion is termed "time consistent.") In contrast, under a rule, it is simply 24 In th is regard, w e stress furth er th at, in contrast to conventional w isdom, th e issue of credibility in monetary policy is not tied to central bank objectives over output. In th e classic, Barro/Gordon (1983) formulation (and countless papers th ereafter), th e central bank's desire to push output above potential output gives rise to th e credibility problem. How ever,, as w e make clear in section 4, gains from commitment poten- tially emerge w h enever private sector beh avior depends on beliefs about th e future, even if cen- tral bank objectives over output are perfectly aligned. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions Clarida, Gal,, Gertler: T h e S cience of Monetary P olicy 1671 th e binding commitment th at makes th e policy believable in equilibrium. S econd, (it sh ould almost go w ith out saying th at) th e models w e use are no- w h ere near th e point w h ere it is possi- ble to obtain a tigh tly specified policy rule th at could be recommended for practical use w ith great confidence. N oneth eless, it is useful to w ork th rough th e cases of discretion and rules in order to develop a set of norma- tive guidelines for policy beh avior. A s T aylor (1993a) argues, common sense application of th ese guidelines may im- prove th e performance of monetary pol- icy. We expand on th is point later. In addition, understanding th e qualitative differences betw een outcomes under discretion versus rules can provide les- sons for th e institutional design of monetary policy. For example, as w e discuss, Rogoff s (1985) insigh tful analysis of th e benefits of a conservative central bank ch air is a product of th is type of analysis. Finally, simply under- standing th e qualitative aspects of opti- mal policy management under discre- tion can provide useful normative insigh ts, as w e sh ow sh ortly. We proceed in th e next section to de- rive th e optimal policy under discretion. In a subsequent section w e th en evaluate th e implications of commitment. 3. Optimal Monetary P olicy w ith out Commitment We begin w ith th e case w ith out com- mitment ("discretion") for tw o reasons. First, at a basic level th is scenario ac- cords best w ith reality. In practice, no major central bank makes any kind of binding commitment over th e course of its future muonetary policy. In th is re- spect, it seems paramount to under- stand th e nature of optimal policy in th is environment. S econd, as w e h ave just discussed, to fully compreh end th e possible gains from commitment to a policy rule and oth er institutional de- vices th at migh t enh ance credibility, it is necessary to understand w h at th e bench mark case of discretion yields. Under discretion, each period th e central bank ch ooses th e triplet {Xt,ltJt}, consisting of th e tw o target variables and th e policy instrument, to maximize th e objective (2.7) subject to th e aggre- gate supply curve (2.2) and th e IS curve, (2.1). It is convenient to divide th e problem into tw o stages: First, th e central bank ch ooses xt and itt to maxi- mize th e objective (2.7), given th e infla- tion equation (2.2).25 T h en, conditional on th e optimal values of xt and it, it de- termines th e value of it implied by th e IS curve (2.1) (i.e., th e interest rate th at w ill support xt and Itt). S ince it cannot credibly manipulate beliefs in th e absence of commitment, th e central bank takes private sector expectations as given in solving th e optimization problem.26 (T h en, condi- tional on th e central bank's optimal rule, th e private sector forms beliefs ra- tionally.) Because th ere are no en- dogenous state variables, th e first stage of th e policy problem reduces to th e fol- low ing sequence of static optimization 25 S ince all th e qualitative results w e derive stem mainly from th e first stage problem, w h at is critical is th e nature of th e sh ort run P h illips curve. For our baseline analysis, w e use th e P h il- lips curve implied th e N ew Keynesian model. In section 6 w e consider a very general P h illips curve th at is a h ybrid of different approach es and sh ow th at th e qualitative results remain intact. It is in th is sense th at our analysis is quite robust. 26 We are ignoring th e possibility of reputational equilibria th at could support a more efficient out- come. T h at is, in th e language of game th eory, w e restrict attention to Markov perfect equilibria. One issue th at arises w ith reputational equilibria is th at th ere are multiplicity of possible equilibria. Rogoff (1987) argues th at th e fragility of th e re- sulting equilibria is an unsatisfactory feature of th is approach . S ee also, Ireland (1996b). On th e oth er h and, Ch ari, Ch ristiano, and Eich enbaum (1998) argue th at th is indeterminacy could provide a source of business fluctuations. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions 1672 Journal of Economic Literature, Vol. XXXVII (December 1999) problems: 27 Each period, ch oose xt and 'A t to maximize - x +st2] +Ft (3.1) 2 subject to it = Xxt +ft (3.2) taking as given Ft andft, w h ere I 001 Ft- - Et{Y pi [ OX2+ + 7C2+ and ft- f=Etntt+I + Ut. Equations (3.1) and (3.2) simply reformulate (2.7) and (2.2) in a w ay th at makes transparent th at, un- der discretion, (a) future inflation and output are not affected by today's ac- tions, and (b) th e central bank cannot directly manipulate expectations. T h e solution to th e first stage prob- lem yields th e follow ing optimality condition: Xt = --t (3.3) ot T h is condition implies simply th at th e central bank pursue a "lean against th e w ind" policy: Wh enever inflation is above target, contract demand below ca- pacity (by raising th e interest rate); and vice-versa w h en it is below target. How aggressively th e central bank sh ould re- duce xt depends positively on th e gain in reduced inflation per unit of output loss, X, and inversely on th e relative w eigh t placed on output losses, (X. T o obtain reduced form expressions for xt and it, combine th e optimality condition (fonc) w ith th e aggregate sup- ply curve (A S ), and th en impose th at private sector expectations are rational: Xt -q ut (3.4) lt = cq ut (3.5) w h ere T h e optimal feedback policy for th e in- terest rate is th en found by simply in- serting th e desired value of xt in th e IS curve (2.1): it = yc Etat + I +-gt (3.6) w h ere 1 + (l >1 EtT t + I= p Itt = poxq Ut T h is completes th e formal description of th e optimal policy. From th is relatively parsimonious set of expressions th ere emerge a number of key results th at are reasonably robust findings of th e literature: Result 1: T o th e extent cost push in- flation is present, th ere exists a sh ort run trade-off betw een inflation and output variability. T h is result w as originally emph asized by T aylor (1979) and is an important guiding principle in many applied stud- ies of monetary policy th at h ave fol- low ed.28 A useful w ay to illustrate th e trade-off implied by th e model is to construct th e corresponding efficient policy frontier. T h e device is a locus of points th at ch aracterize h ow th e uncon- ditional standard deviations of output and inflation under th e optimal policy, ox and (7, vary w ith central bank prefer- ences, as defined by ot. Figure 1 por- trays th e efficient policy frontier for our 27 In section 6, w e solve for th e o ptimum under discretion for th e case w h ere an en dogenous state variable is present. With in th e Mar ov perfect equilibrium, th e central bank takes private sector beliefs as a given function of th e endogenous state. 28 For some recent examples, see Williams (1997), Fuh rer (1997a) and Orph anides, S mall, Wilcox and Wieland (1997). A n exception, h ow - ever, is Jovanovic and Ueda (1997) w h o demon- strate th at in an environment of incomplete con- tracting, increased dispersion of prices may reduce output. S tabilizing prices in th is environment th en raises output. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions Clarida, Galt', Gertler: T h e S cience of Monetary P olicy 1673 8- 7 6 51 o "t OC5 t- t- "It O C 5) Q Cq t m Q - 00 o C' m6 6 o6 o6 o6 o06 & C O C 0 s 6 sd(inflation) Figure 1. Efficient P olicy Frontier for th e Baseline Model baseline model.29 In ( space th e locus is dow nw ard sloping and convex to th e origin. P oints to th e righ t of th e frontier are inefficient. P oints to th e left are infeasible. A long th e frontier th ere is a trade-off: A s ox rises (indicat- ing relatively greater preference for output stability), th e optimal policy en- gineers a low er standard deviation of output, but at th e expense of h igh er in- flation volatility. T h e limiting cases are instructive: A so*O: ox=-; o=O (3.7) A s o o e : 6x=O ; On (Y (3.8) w h ere cu is th e standard deviation of th e cost push innovation. It is important to emph asize th at th e trade-off emerges only if cost push in- flation is present. In th e absence of cost inflation (i.e., w ith (u = 0), th ere is no trade-off. In th is instance, inflation de- pends only on current and future de- mand. By adjusting interest rates to set Xt = 0, V t, th e central bank is able to h it its inflation and output targets simulta- neously, all th e time. If cost push fac- tors drive inflation, h ow ever, it is only possible to reduce inflation in th e near term by contracting demand. T h is consideration leads to th e next result: Result 2: T h e optimal policy incorpo- rates inflation targeting in th e sense th at it requires to aim for convergence of inflation to its target over time. Ex- treme inflation targeting, h ow ever, i.e., adjusting policy to immediately reach an inflation target, is optimal under only one of tw o circumstances: (1) cost push inflation is absent; or (2) th ere is no concern for output deviations (i.e., ==O). In th e general case, w ith ox > 0 and (u > 0, th ere is gradual convergence of inflation back to target. From equations (3.5) and (2.4), under th e optimal policy lim Et{itt + i= lim (xqpi ut = 0 i -4 00 i o0 29 Equations (3.4) and (3.5) define th e frontier for th e baseline model. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions 1674 Journal of Economic Literature, Vol. XXXVII (December 1999) In th is formal sense, th e optimal pol- icy embeds inflation targeting.30 With exogenous cost push inflation, policy af- fects th e gap betw een inflation and its target along th e convergent path , but not th e rate of convergence. In con- trast, in th e presence of endogenous in- flation persistence, policy w ill generally affect th e rate of convergence as w ell, as w e discuss later. T h e conditions for extreme inflation targeting can be seen immediately from inspection of equations (3.7) and (3.8). Wh en cu = 0 (no cost push inflation), adjusting policy to immediately h it th e inflation target is optimal, regardless of preferences. S ince th ere is no trade-off in th is case, it is never costly to try to minimize inflation variability. Inflation being th e only concern of policy pro- vides th e oth er rationale for extreme in- flation targeting. A s equation (3.7) indi- cates, it is optimal to minimize inflation variance if x = 0, even w ith cost push inflation present. Result 2 illustrates w h y some con- flicting view s about th e optimal transi- tion path to th e inflation target h ave emerged in th e literature. Marvin Goodfriend and Robert King (1997), for example, argue in favor of extreme in- flation targeting. S vensson (1997a,b) and Laurence Ball (1997) suggest th at, in general, gradual convergence of in- flation is optimal. T h e difference stems from th e treatment of cost push infla- tion: It is absent in th e Goodfriend- King paradigm, but very much a factor in th e S vensson and Ball framew orks. Results 1 and 2 pertain to th e beh av- ior of th e target variables. We now state several results regarding th e beh avior of th e policy instrument, it. Result 3: Under th e optimal policy, in response to a rise in expected infla- tion, nominal rates sh ould rise suffi- ciently to increase real rates. P ut differ- ently, in th e optimal rule for th e nominal rate, th e coefficient on expected inflation sh ould exceed unity. Result 3 is transparent from equation (3.6). It simply reflects th e implicit tar- geting feature of optimal policy de- scribed in Result 2. Wh enever inflation is above target, th e optimal policy re- quires raising real rates to contract de- mand. T h ough th is principle may seem obvious, it provides a very simple crite- ria for evaluating monetary policy. For example, Clarida, Galf, and Gertler (forth - coming) find th at U.S . monetary policy in th e pre-Volcker era of 1960-79 vio- lated th is strategy. Federal Reserve pol- icy tended to accommodate rath er th an figh t increases in expected inflation. N ominal rates adjusted, but not suffi- ciently to raise real rates. T h e persis- tent h igh inflation during th is era may h ave been th e end product of th e fail- ure to raise real rates under th ese cir- cumstances. S ince 1979, h ow ever, th e Federal Reserve appears to h ave adopted th e kind of implicit inflation targeting strategy th at equation (3.6) suggests. Over th is period, th e Fed h as systemati- cally raised real rates in response to an- ticipated increases in inflationary ex- pectations. We return to th is issue later. Result 4: T h e optimal policy calls for adjusting th e interest rate to perfectly off- set demand sh ocks, gt, but perfectly ac- commodate sh ocks to potential output, zt, by keeping th e nominal rate constant. T h at policy sh ould offset demand sh ocks is transparent from th e policy rule (3.6). Here th e simple idea is th at countering demand sh ocks push es both output and inflation in th e righ t direc- tion. Demand sh ocks do not force a 30 N ote h ere th at our definition is somew h at different from S vensson (1997a), w h o defines inflation targeting in terms of th e w eigh ts on th e objective function, i.e., h e defines th e case w ith x= O as corresponding to strict inflation targeting and ox > 0 as corresponding to flexible inflation targeting. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions Clarida, Galt', Gertler: T h e S cience of Monetary P olicy 1675 sh ort run trade-off betw een output and inflation. S h ocks to potential output also do not force a sh ort run trade-off. But th ey re- quire a quite different policy response. T h us, e.g., a permanent rise in produc- tivity raises potential output, but it also raises output demand in a perfectly off- setting manner, due to th e impact on permanent income.31 A s a consequence, th e output gap does not ch ange. In turn, th ere is no ch ange in inflation. T h us, th ere is no reason to raise inter- est rates, despite th e rise in output.32 Indeed, th is kind of scenario seems to describe w ell th e current beh avior of monetary policy. Output grow th w as substantially above trend in recent times, but w ith no apparent accompanying in- flation.33 Based on th e view th at th e rise in output may mainly reflect productivity movements, th e Federal Reserve h as resisted large interest rate increases. T h e central message of Result 4 is th at an important task of monetary pol- icy is to distinguish th e sources of business cycle sh ocks. In th e simple environment h ere w ith perfect ob- servability, th is task is easy. Later w e explore some implications of relaxing th is assumption. 4. Credibility and th e Gains from Commitment S ince th e pioneering w ork of Kydland and P rescott (1977), Robert Barro and David Gordon (1983), and Rogoff (1985), a voluminous literature h as de- veloped on th e issue of credibility of monetary policy.34 From th e standpoint of obtaining practical insigh ts for pol- icy, w e find it useful to divide th e pa- pers into tw o strands. T h e first follow s directly from th e seminal papers and h as received by far th e most attention in academic circles. It emph asizes th e problem of persistent inflationary bias under discretion.35 T h e ultimate source of th is inflationary bias is a central bank th at desires to push output above its natural level. T h e second is emph asized more in applied discussions of policy. It focuses on th e idea th at disinflating an economy may be more painful th an nec- essary, if monetary policy is perceived as not devoted to figh ting inflation. Here th e source of th e problem is simply th at w age and price setting today may depend upon beliefs about w h ere prices are h eaded in th e future, w h ich in turn depends on th e course of monetary policy. T h ese tw o issues are similar in a sense: T h ey both suggest th at a central bank th at can establish credibility one w ay or anoth er may be able to reduce inflation at low er cost. But th e source of th e problem in each case is different in subtle but important w ays. A s a consequence th e potential empirical relevance may differ, as w e discuss below . We first use our model to exposit th e famous inflationary bias result. We th en illustrate formally h ow credibility can reduce th e cost of maintaining low in- flation, and also discuss mech anisms in 31 In th is experiment w e are h olding constant th e IS sh ock gt S ince gt = [(et - Zt) - Et(et + I - Zt + 1)], (see footnote 9), th is boils dow n to assuming eith er th at th e sh ock to Zt is permanent (so th at Etzt + 1 - Zt = 0) or th at et adjusts in a w ay to offset movements in gt. 32 T h at monetary policy sh ould accommodate movements in potential GDP is a th eme of th e recent literature (e.g., A iyagari and Braun 1997; Carlstrom and Fuerst 1995; Ireland 1996a; and Rotemberg and Woodford 1997). T h is view w as also stressed in much earlier literature. S ee Fried- man and Kuttner (1996) for a review . 33 S ee Low n and Rich (1997) for a discussion of th e recent "inflation puzzle." 34For recent surveys of th e literature, see Fis- ch er (1995), McCallum (1997) and P ersson and T abellini (1997). 35Wh ile th e inflationary bias result is best know n example, th ere may also be oth er costs of discretion. S vennson (1997c), for example, argues also th at discretion may lead to too much inflation variability and too little output variability. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions 1676 Journal of Economic Literature, Vol. XXXVII (December 1999) th e literature th at h ave been suggested to inject th is credibility. A n important result w e w ish to stress-and one th at w e don't th ink is w idely understood in th e literature-is th at gains from credi- bility emerge even w h en th e central bank is not trying to push output above its natural level.36 T h at is, as long as price setting depends on expectations of th e future, as in our baseline model, th ere may be gains from establish ing some form of credibility to curtail infla- tion. Furth er, under certain plausible restrictions on th e form of th e feedback rule, th e optimal policy under commit- ment differs from th at under discretion in a very simple and intuitive w ay. In th is case, th e solution w ith commitment resembl6s th at obtained under discre- tion using a h igh er effective cost ap- plied to inflation th an th e social w elfare function suggests.37 In th is respect, w e th ink, th e credibility literature may h ave some broad practical insigh ts to offer. 4.1 T h e Classic Inflationary Bias P roblem A s in Kydland and P rescott (1979), Barro and Gordon (1983), and many oth er papers, w e consider th e possibil- ity th at th e target for th e output gap may be k > 0, as opposed to 0. T h e policy objective function is th en given by ma--E Y (4.1) max-2E , pi[ o(xt +i -k)2 + R2+,]; 41 2 O T h e rationale for h aving th e socially opti- mal level of output exceed its natural level may be th e presence of distortions such as imperfect competition or taxes. For convenience, w e also assume th at price setters do not discount th e future, w h ich permits us to fix th e parameter , in th e P h illips curve at unity.38 In th is case, th e optimality condi- tion th at links th e target variables is given by: k Xk xt = --sCt +k (4.2) T h e superscript k indicates th e variable is th e solution under discretion for th e case k > 0. P lugging th is condition into th e IS and P h illips curves, (2.1) and (2.2), yields: Xt =Xt (4.3) XtCk =ct + Xk (4.4) w h ere xt and 't are th e equilibrium val- ues of th e target variables for th e base- line case w ith k = 0 (see equations 3.4 and 3.5). N ote th at output is no different from th e baseline case, but th at inflation is systematically h igh er, by th e factor o k. T h us, w e h ave th e familiar result in th e literature: Result 5. If th e central bank desires to push output above potential (i.e., k > 0), th en under discretion a subopti- mal equilibrium may emerge w ith infla- tion persistently above target, and no gain in output. T h e model w e use to illustrate th is 36A number of papers h ave sh ow n th at a disin- flation w ill be less painful if th e private sector per- ceives th at th e central bank w ill carry it out. But th ey do not sh ow formally th at, under discretion, th e central bank w ill be less inclined to do so (see., e.g. Ball 1995, and Bonfim and Rudebusch 1997). 37With inflationary bias present, it is also possi- ble to improve w elfare by assigning a h igh er cost to inflation, as Rogoff (1985) originally emph a- sized. But it is not alw ays possible to obtain th e optimum under commitmelnt. T h e point w e em- ph asize is th at w ith inflationary bias absent, it is possible to replicate th e solution under commit- ment (for a restricted family of policy rules) using th e algorith m to solve for th e optimum under dis- cretion w ith an appropriately ch osen relative cost of inflation. We elaborate on th ese issues later in th e text. 38 Oth erw ise, th e discounting of th e future by price-setters introduces a long-run trade-off be- tw een inflation and output. Under reasonable pa- rameter values th is tradeoff is small and its pres- ence merely serves to complicate th e algebra. S ee Goodfriend and King (1997) for a discussion. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions Clarida, Gall, Gertler: T h e S cience of Monetary P olicy 1677 result differs from th e simple expecta- tional P h illips curve framew ork in w h ich it h as been typically studied. But th e intuition remains th e same. In th is instance, th e central bank h as th e in- centive to announce th at it w ill be tough in th e future to low er current in- flation (since in th is case, current infla- tion depends on expected future infla- tion), but th en expand current demand to push output above potential. T h e presence of k in th e optimality condi- tion (4.2) reflects th is temptation. A ra- tional private sector, h ow ever, recog- nizes th e central bank's incentive. In mech anical terms, it makes use of equa- tion (4.2) to forecast inflation, since th is condition reflects th e central bank's true intentions. P ut simply, equilibrium inflation rises to th e point w h ere th e central bank no longer is tempted to ex- pand output. Because th ere is no long- run trade-off betw een inflation and out- put (i.e., xt converges to zero in th e long run, regardless of th e level of infla- tion), long-run equilibrium inflation is forced systematically above target. T h e analysis h as both important posi- tive and normative implications. On th e positive side, th e th eory provides an ex- planation for w h y inflation may remain persistently h igh , as w as th e case from th e late 1960s th rough th e early 1980s. Indeed, its ability to provide a qualita- tive account of th is inflationary era is a major reason for its popularity. T h e w idely stressed normative impli- cation of th is analysis is th at th ere may be gains from making binding commit- ments over th e course of monetary pol- icy or, alternatively, making institu- tional adjustments th at accomplish th e same purpose. A clear example from th e analysis is th at w elfare w ould improve if th e central bank could simply commit to acting as if k w ere zero. T h ere w ould be no ch ange in th e path of output, but inflation w ould decline. Imposing binding commitments in a model, h ow ever, is much easier th an do- ing so in reality. T h e issue th en becomes w h eth er th ere may be some simple in- stitutional mech anisms th at can approxi- mate th e effect of th e idealized policy commitment. P erh aps th e most useful answ er to th e question comes from Rogoff (1985), w h o proposed simply th e appoint- ment of a "conservative" central banker, taken in th is context to mean someone w ith a greater distaste for inflation (a low er ot), th an society as a w h ole: Result 6: A ppointing a central bank ch air w h o assigns a h igh er relative cost to inflation th an society as a w h ole re- duces th e inefficient inflationary bias th at is obtained under discretion w h en k > 0. One can see plainly from equation (4.4) th at letting someone w ith prefer- ences given by OCR< ox run th e central bank w ill reduce th e inflationary bias.39 T h e Rogoff solution, h ow ever, is not a panacea. We know from th e earlier analysis th at emph asizing greater reduc- tion in inflation variance may come at th e cost of increased output variance. A ppointing an extremist to th e job (someone w ith oX at or near zero) could w ind up reducing overall w elfare. How important th e inflationary bias problem emph asized in th is literature is in practice, h ow ever, is a matter of con- troversy. Benjamin Friedman and Ken- neth Kuttner (1996) point out th at in- flation in th e major OECD countries now appears w ell under control, despite th e absence of any obvious institutional ch anges th at th is literature argues are needed to enh ance credibility. If th is th eory is robust, th ey argue, it sh ould account not only for th e h igh inflation of th e 1960s and 1970s, but also for th e 39S ee S vensson (1997) and Walsh (1998) for a description of h ow incentive contracts for central bankers may reduce th e inflation bias; also, Faust and S vensson (1998) for a recent discussion of reputational mech anisms. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions 1678 Journal of Economic Literature, Vol. XXXVII (December 1999) transition to an era of low inflation dur- ing th e 1980s and 1990s. A possible counterargument is th at in fact a num- ber of countries, including th e U.S ., ef- fectively adopted th e Rogoff solution by appointing central bank ch airs w ith clear distaste for inflation. A noth er strand of criticism focuses on th e plausibility of th e underlying story th at leads to th e inflationary bias. A number of prominent auth ors h ave argued th at, in practice, it is unlikely th at k > 0 w ill tempt a central bank to ch eat. A ny rational central bank, th ey maintain, w ill recognize th e long-term costs of misleading th e public to pursue sh ort-term gains from push ing output above its natural level. S imply th is rec- ognition, th ey argue, is sufficient to constrain its beh avior (e.g. McCallum 1997a; Blinder 1997). Indeed, Blinder argues, based on h is ow n experience on th e Federal Reserve Board, th at th ere w as no constituency in favor of pursuing output gains above th e natural rate. In formal terms, h e maintains th at th ose w h o run U.S . monetary policy act as if th ey w ere instructed to set k = 0, w h ich eliminates th e inflationary bias. Wh at is perh aps less understood, h ow ever, is th at th ere are gains from enh ancing credibility even w h en k = 0. T o th e extent th at price setting today depends on beliefs about future eco- nomic conditions, a monetary auth ority th at is able to signal a clear commit- ment to controlling inflation may face an improved sh ort-run output/inflation trade-off. Below w e illustrate th is point. T h e reason w h y th is is not emph asized in much of th e existing literature on th is topic is th at th is w ork eith er tends to focus on steady states (as opposed to sh ort-run dynamics), or it employs very simple models of price dynamics, w h ere current prices do not depend on beliefs about th e future. In our baseline model, h ow ever, sh ort-run price dynamics de- pend on expectations of th e future, as equation (2.2) makes clear.40 4.2 Improving th e S h ort-Run Output/lInflation T rade-off: Gains from Commitment w ith k = 0. We now illustrate th at th ere may be gains from commitment to a policy rule, even w ith k = 0. T h e first stage problem in th is case is to ch oose a state contin- gent sequence for xt+i and nt+i to maxi- mize th e objective (2.7) assuming th at th e inflation equation (2.2) h olds in every period t + i, i ? 0. S pecifically, th e central bank no longer takes private sec- tor expectations as given, recognizing instead th at its policy ch oice effectively determines such expectations. T o illustrate th e gains from commit- ment in a simple w ay, w e first restrict th e form of th e policy rule to th e gen- eral form th at arises in equilibrium un- der discretion, and solve for th e opti- mum w ith in th is class of rules. We th en sh ow th at, w ith commitment, anoth er rule w ith in th is class dominates th e op- timum under discretion. Hence th is ap- proach provides a simple w ay to illus- trate th e gains from commitment. A noth er positive byproduct is th at th e restricted optimal rule w e derive is sim- ple to interpret and implement, yet still yields gains relative to th e case of dis- cretion. Because th e policy is not a global optimum, h ow ever, w e conclude th e section by solving for th e unrestricted optimal rule. 4.2.1 Monetary P olicy under Commitment: T h e Optimum w ith in a S imple Family of P olicy Rules (th at includes th e optimal rule under discretion) In th e equilibrium w ith out commit- ment, it is optimal for th e central bank 40 T h is section is based on Gali and Gertler (1999). This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions Clarida, Gal', Gertler: T h e S cience of Monetary P olicy 1679 to adjust xt solely in response to th e exogenous cost push sh ock, ut. We ac- cordingly consider a rule for th e target variable xt th at is contingent on th e fundamental sh ock ut, in th e follow ing w ay: xtC= -(out (4.5) for all t, w h ere Wo > 0 is th e coefficient of th e feedback rule, and w h ere xc denotes th e value of xt conditional on commit- ment to th e policy.4' N ote th at th e rule includes th e optimum under discretion as a special case (i.e., th e case w ith w o = Xq sh ow n in 3.4). Combining equation (4.5) w ith th e P h illips curve (2.2), in turn, implies th at inflation under th e rule, t, is also a lin- ear function of th e cost push sh ock: RC = X xc + C Etc+ + ut (4.6) = Etl P i [XC+ +ut+i] (4.7) i=O =EtX P i [-Xout+i +ut+i] (4.8) i=O U 1? t (4.9) 1-p T h e problem for th e central bank is to ch oose th e optimal value of th e feed- back parameter co. Relative to th e case of discretion, th e ability to commit to a feedback policy provides th e central bank w ith an improved sh ort-run out- put/inflation trade-off. T o th is end, note th at it is possible to express equation (4.9) as C _ 1 XtC xtc+ Ut l-f3p 1- t (4.10) In th is case, a one percent contraction in xc reduces 7uc by th e factor lx Under t t I ~~~~~~- 3p. discretion, reducing xt by one percent only produces a fall in 2t of < l T h e extra kick in th e case w ith commit- ment is due to th e impact of th e policy rule on expectations of th e future course of th e output gap. In particular, th e ch oice of o affects not only xt but also beliefs about th e course of xt,+, i = 1,2, since Etx+i = - cOut. A central bank th at commits to a tough policy rule (h igh o), for example, is able to credibly signal th at it w ill sustain over time an aggres- sive response to a persistent supply sh ock. S ince inflation depends on th e future course of excess demand, commitment to th e tough policy rule leads to a magni- fied drop in inflation per unit of output loss, relative to th e case of discretion. T o find th e optimal value of o, note first th at since x+i and lT cci are each a constant multiple of th e cost push sh ock ut+i, it is possible to express th e objec- tive function as a multiple of period t loss: max- - Et f i[a (Xc+4)2 + (sT C+.)2] =0 <-) max - 2 [a (XC)2 + (7tC)2]Lt (4.11) 001 w ith Lt Et Ii(Ut + iUt)2 > 0. T h e prob- lem th en is to ch oose o to maximize (4.11), subject to (4.10). In th is instance, th e optimality condition is given by: 4t= c (4.12) w h ere (xc = (1f3 - p) < ot (4.13) S ince xc < ca, relative to th e case of dis- cretion, commitment to th e rule implies th at it is optimal for th e central bank to engineer a greater contraction in output in response to inflationary pressures. Intuitively, th e more aggressive response 41 T h e policy rule only depends on ut because th e central bank can adjust it to offset any impact of movements in gt on aggregate demand. S ee equation (4.16). This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions 1680 Journal of Economic Literature, Vol. XXXVII (December 1999) to inflation is th e product of th e im- proved output/inflation trade-off th at commitment affords. S pecifically, th e output cost of low ering inflation declines from ox to 0cc per unit, since reducing in- flation a given amount requires, ceteris paribus, only a fraction (1 - fp) of th e output loss required under discretion. T h e decline in th e effective cost of re- ducing inflation, in turn, induces th e more aggressive policy response to infla- tion, as comparing equation (4.12) w ith equation (3.3) makes clear. T h e equilibrium solutions for xc and stc are easily obtained by combining equations (4.12) and (4.10): xc= Xqc ut (4.14) tC = _ ccqcut (4.15) w ith X 2 + OCc(l - pp) It is interesting to observe th at th e solution under commitment in th is case perfectly resembles th e solution ob- tained under discretion th at arises w h en at is replaced w ith 0c < <a in th e objec- tive function. It follow s th at, condi- tional on th e value of th e cost push sh ock, ut, inflation is closer to target and output is furth er, relative to th e outcome under discretion.42 It is straigh tforw ard to verify th at commitment to th e policy rule raises w elfare.43 T h e tension produced by such gains from commitment, w e th ink, is compelling from an empirical stand- point. Because inflation depends on ex- pected future output gaps, th e central bank w ould like to convince th e private sector th at it w ill be tough in th e fu- ture, but at th e same time, not to h ave to contract demand much today. A s th e future comes to pass, th e central bank h as th e incentive to renege on its planned tough ness and, instead, prom- ise again to undertake contractionary policy dow n th e road. T o see th is, sup- pose th at th ere is a positive cost push sh ock. If th e central bank is free to de- viate from th e rule, it w ill alw ays ch oose th e optimal policy under discretion, w h ich calls for a smaller contraction of output, relative to th e case of commit- ment (again, compare 4.1 and 3.3). A rational private sector w ill recognize th at incentive and, unless th e central bank is able to commit credibly, w ill not expect large contractions in demand in th e future eith er. A s a result, th e cost push sh ock generates h igh er inflation in th e absence of commitment. We stress again th at, in contrast to th e traditional analysis, th is gain from commitment is not tied to th e desire of th e central bank to push output above potential, but to th e forw ard-looking nature of in- flation (and, th us, th e importance of ex- pectations about future policy) in our baseline model. From a policy standpoint, Rogoff's ra- tionale for a conservative central banker carries over perfectly to th is case. In- deed w ith omniscience (i.e. exact know ledge of xc and th e true model), an appropriately ch osen central banker could replicate th e outcome under commitment. We summarize th e findings in Result 7: Result 7: If price-setting depends on expectations of future economic condi- tions, th en a central bank th at can cred- ibly commit to a rule faces an improved sh ort-run trade-off betw een inflation 42 Importantly, w ith endogenous inflation per- sistence, commitment produces a faster transition of inflation to target, as w e discuss later. 43 T o verify th at commitment raises w elfare, simply substitute th e implied values for xt and ;t under th e optimal rule for each case into th e pol- icy objective function. How ever, it sh ould be obvi- ous th at commitment raises w elfare, since th e op- timal rule under discretion falls w ith in th e class of rules th at w e permitted th e central bank to ch oose in th e case w ith commitment: Yet w e found th at w ith commitment it is optimal to ch oose a differ- ent parameterization of th e rule th an arises in th e optimum under discretion. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions Clarida, Galf, Gertler: T h e S cience of Monetary P olicy 1681 and output. T h is gain fromn commnitmnent arises even if th e central bank does not prefer to h ave output above potential (i. e., even w h en k = 0). T h e solution under commitment in th is case perfectly resembles th e solution th at w ould ob- tain for a central bank w ith discretion th at assigned to inflation a h igh er cost th an th e true social cost. One additional interesting feature of th is case w ith commitment involves th e beh avior of interest rates. T h is can be seen formally by simply replacing oc w ith cxc in th e interest rate rule under discretion (given by equation 3.6) to obtain it =7 Eau +1 -t (4.16) w ith C 1 +(1-P )X (1-p) X 7 +P (P (XC P P Y In particular, relative to th e case of dis- cretion, th e central bank increases th e nominal interest rate by a larger amount in response to a rise in expected inflation. 4.2.2 Monetary P olicy under Commit- ment: T h e Unconstrained Optimum We now provide a brief description of th e general solution for th e optimal pol- icy under commitment.44 Because th e derivation is more cumbersome th an for th e restricted case just described, w e defer most of th e details to an appen- dix. A s w ith th e simple fundamental based policy, h ow ever, th e general solu- tion exploits th e ability th at commit- ment affords to manipulate private sector expectations of th e future. T h e first stage problem remains to ch oose a state-contingent sequence for xt+i and tKt+i to maximize th e objective (2.7) given th at th e aggregate supply curve (2.2) h olds in every period t + i, i > O. We no longer restrict th e ch oice of xt to depend on th e contempo- raneous value of th e sh ock (i.e., ut ), but allow instead for rules th at are a func- tion of th e entire h istory of sh ocks. T o find th e globally optimal solution to th e linear quadratic policy problem under commitment, w e follow David Currie and P aul Levine (1993) and Woodford (1998), and form th e Lagrangian: 45 max- - Et pi [3Xz2+ i+ 2 2 [i= (4.17) + P t+i(tt+i - Xxt+i - tt+i+ I -Ut+i)]} w h ere I Ot +i is th e (state-contingent) multiplier associated w ith th e constraint at t+i. It is straigh tforw ard to sh ow th at th e first order conditions yield th e follow ing optimality conditions Xt+i-Xt+i- 1=: - Xut+i, fori = 1,2,3,... (4.18) and Xt --tet (4.19) cx Recall th at under discretion th e opti- mal policy h as th e central bank adjust th e level of th e output gap in response to inflation. T h e optimal policy under commitment requires instead adjusting th e ch ange in th e output gap in re- sponse to inflation. In oth er w ords, commitment ch anges th e level rule for xt under discretion into a difference rule for xt, as a comparison of equations 44We th ank Ch ris S ims and A lbert Marcet for calling to our attention th at th e globally optimal rule under commitment w ould likely not fall w ith in th e restricted family of rules considered in th e previous sub-section. 45S ee also King and Wolman, w h o analyze th e optimal monetary policy under commitment in a version of T aylor's (1980) staggered contracts model. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions 1682 Journal of Economic Literature, Vol. XXXVII (December 1999) (3.3) and (4.8) indicates.46 T h e one ca- veat is th at in th e initial period th e pol- icy is implemented (i.e., period t) th e central bank sh ould simply adjust th e level of th e output gap xt is response to itt, as if it w ere follow ing th e optimal policy under discretion, but for th at period only. Because xt+i depends in general on xt + i - 1, th e (unconstrained) optimal pol- icy under commitment is in general not simply a function of th e contemporane- ous state variable ut + i. A s Woodford (1998) emph asizes in a related context, th e lagged dependence in th e policy rule arises as a product of th e central bank's ability under commitment to di- rectly manipulate private sector expec- tations.47 T o see th is for our framew ork, keep in mind th at itt depends not only on current xt but also on th e expected future path of xt+i. T h en suppose, for example, th at th ere is a cost push sh ock th at raises inflation above target at time t. T h e optimal response under discre- tion, as w e h ave seen, is to reduce Xt, but th en let xt+i revert back to trend over time as it+i falls back to target. T h e optimal policy under commitment, h ow ever, is to continue to reduce xt + as long as it+i remains above target. T h e (credible) th reat to continue to contract xt in th e future, in turn, h as th e imme- diate effect of dampening current infla- tion (given th e dependency of itt on fu- ture values of xt). Relative to th e case of discretion, accordingly, th e cost push sh ock h as a smaller impact in current inflation.48 A s w ith th e constrained policy, th e globally optimal policy under commit- ment exploits th e ability of th e central bank to influence ntt w ith expected fu- ture values of xt+i as w ell as current xt. It is also easy to see th at, as w as th e case w ith th e more restrictive rule, th e policy is not time consistent. Clearly, if it could reoptimize at t +i, th e central bank w ould ch oose th e same policy it implemented at t, th e one w h ich mimics th e rule under discretion for th e first period only. A disadvantage of th e unconstrained optimal policy under commitment is th at it appears more complex to imple- ment th an th e constrained one (de- scribed by equation 4.12). A s w e h ave seen, th e constrained rule resembles in every dimension th e optimal policy un- der discretion, but w ith relatively more w eigh t placed on figh ting inflation. A c- cordingly, as w e discussed, it is possible to approximate th is policy under discre- tion w ith an appropriately ch osen cen- tral banker. T h e same is not true, h ow - ever, for th e unconstrained optimal policy. A conservative central banker operating w ith discretion h as no obvi- ous incentive to stick to th e difference rule for th e output gap implied by equation (4.18). A furth er complication, discussed at length in Woodford (1998), is th at th e interest rate rule th at implements th e optimal policy migh t h ave undesirable 46Woodford (1998) makes th e connection be- tw een th e lagged dependence in th e optimal rule under commitment and th e lagged dependence th at appears to arise in interest rate beh avior un- der practice (see section 5.2). Rough ly speaking, since th e interest rate affects th e output gap, lagged dependence in th e latter translates into lagged dependence in th e former. 47Woodford (1998) considers a closely related environment. T h e difference is th at in h is frame- w ork th e policy-maker confronts a trade-off be- tw een inflation and th e output gap ultimately be- cause h is objective function includes a target for th e nominal interest rate (along w ith targets for th e output gap and inflation), w h ereas in our framew ork th e trade-off arises due to th e cost push sh ock. 48 On th e surface it appears th at th e difference rule for xt migh t be unstable. How ever, itt adjusts to ensure th at th is is not th e case. In particular, th e optimal response to a positive cost push sh ock is to contract xt sufficiently to push itt below tar- get. xt th en adjusts back up to target over time. T h e appendix provides th e details. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions Clarida, Galt, Gertler: T h e S cience of Monetary P olicy 1683 side effects. T o see th is, combine (4.18) and (2.1) to obtain th e implied optimal interest rate rule it= 1-- Eaut + I +-gt N otice th at th e coefficient associated w ith expected inflation is less th an one. Under th is rule, accordingly, a rise in anticipated inflation leads to a decline in th e real interest rate. A s w e discuss in section 7, if inflationary pressures vary inversely w ith th e real rate, a rule of th is type may permit self-fulfilling fluctuations in output and inflation th at are clearly suboptimal.49 Overall, w e h ave: Result 8: T h e globally optimal policy rule under commitment h as th e central bank partially adjust demand in re- sponse to inflationary pressures. T h e idea is to exploit th e dependence of cur- rent inflation on expected future de- mand. In addition, w h ile appointing a conservative central banker may raise w elfare under discretion (see Result 7), it does not appear th at it is possible to attain th e globally optimal rule w ith th is strategy. Finally, th ere may be some practical complications in implementing th e globally optimal interest rate rule th at involve potential indeterminacy, as discussed in Woodford (1998). We conclude th at, th ough substantial progress h as been made, our under- standing of th e full practical implica- tions of commitment for policy-making is still at a relatively primitive stage, w ith plenty of territory th at is w orth exploring. 5. P ractical Complications In th is section w e consider a number of important practical issues th at com- plicate th e implementation of monetary policy. Wh ile th ey may not be as exotic as th e question of credibility, th ey are no less important for th e day-to-day for- mulation of policy. 5.1 Imperfect Information T h us far w e h ave assumed th at th e central bank is able to control perfectly th e path s of th e key target variables. In practice, of course, th is is not th e case. One important reason is imperfect ob- servability. A t th e time it sets interest rates, a central bank may not h ave all th e relevant information available about th e state of th e economy. Certain data take time to collect and process. S am- pling is imperfect. Even if it h as access to data in real time, some key variables such as th e natural level of output are not directly observable and are likely measured w ith great error (see, e.g., th e discussion in A rturo Estrella and Mish kin 1999 and Orph anides 1998). Beyond limiting th e efficacy of pol- icy, imperfect information h as several specific implications. First, it is no longer possible to specify rules simply in terms of target variables. With per- fect information, a policy may be ex- pressed equivalently in terms of targets or instruments since a one-to-one rela- tionsh ip generally exists betw een th ese variables. With imperfect information, rules for targets can be expressed only in terms of th e respective forecasts, as opposed to th e ex-post values. A n alter- native is to use an intermediate target th at is directly observable, such as a broad monetary aggregate. S econd, imperfect information makes th e policy instrument ch oice non-trivial. With perfect information, for example, it does not matter w h eth er th e central 49Indeterminacy does not arise in th e case of discretion or in th e case of th e constrained opti- mum under commitment, since in each instance th e implied interest rate rule h as an inflation coef- ficient greater th an one. T o th e extent th at such coefficient is not too large, implementation of such a rule w ill result in a unique equilibrium (see th e discussion in section 7 and also in Clarida, Galf, and Gertler (1998). This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions 1684 Journal of Economic Literature, Vol. XXXVII (December 1999) bank uses th e sh ort-term interest rate or a monetary aggregate as th e policy instrument, so long as th e money de- mand function yields a monotonic rela- tion betw een th e tw o variables.50 With imperfect information, th e ex post vola- tility of a variety of key variables h inges on th e instrument ch oice, as originally argued by William P oole (1970). We illustrate each of th ese issues below .5' 5.1.1 Forecasts as T argets and Intermediate T argets We now return to th e baseline model w ith no commitment, and modify it as follow s. S uppose th at th e central bank cannot observe th e contemporaneous values of output, inflation, or any of th e random sh ocks. T h en let Qt be th e cen- tral bank's information set at th e time it fixes th e interest rate th at prevails at time t.52 T h e optimality condition for policy now is expressed in terms of th e expected as opposed to realized target variables. E{xt IQt = --EtIT t (5.1) Equation (5.1) is th e certainty equivalent version of th e condition for th e case of perfect information, given by equation (3.3). Certainty equivalence applies h ere because of th e linear quadratic setup (th at gives linear decision rules under perfect information) and because th e er- rors in forecasting th e target variables are additive. For ease of exposition, assume th at th ere is no serial correlation in th e cost push sh ock; th at is, p = 0, so th at Ut = ut. T h e implied equilibrium values of th e target variables under imperfect information, xi and 7d, are given by Xt Xt + Ut + gtj gt (5.2) ;t(1 +_ )fl;t + Xgt = Ut + kgt (5.3) w h ere xt and ntt are th e optimal values of th e target variables th at emerge in case of perfect information (w h en ut is serially uncorrelated),53 and w h ere ut and gt are th e unexpected movements in th e cost push and demand sh ocks, respectively. Im- perfect information clearly implies greater volatility of inflation, since th e central bank cannot immediately act to offset th e impact of th e sh ocks. T h e net effect on th e volatility of th e output gap is un- clear: th e inability to offset th e demand sh ock clearly raises output volatility. On th e oth er h and, th e central bank cannot offset th e inflationary impact of th e cost push sh ock, w h ich w orks to reduce th e volatility of th e output. T h ere is, h ow ever, an unambiguous reduction in w elfare.54 One additional result is w orth noting. S ince demand sh ocks now affect th e be- h avior of output, a positive sh ort-run co-movement betw een inflation and output can emerge if gth as a variance sufficiently large relative to th at of uat. It is straigh tforw ard to generalize th e analysis to a setting w h ere th e imper- fect observability stems from lags in th e 50T o clarify, a money aggregate can serve as an instrument only if it is directly controllable. A can- didate aggregate th en w ould be bank reserves. A broad aggregate such as M3 w ould not qualify. 51 For a broad survey of th e literature on mone- tary policy targets and instruments, see Friedman (1991). 52 T h us, Qt is similarly th e private sector's infor- mation set. S pecifically, w e let firms observe th e current values of th eir marginal costs, but neith er firms nor h ouseh olds can observe contemporane- ous aggregate variables. In th is instance, th e IS and P h illips curve equations are respectively given by xt = - 9[(it I Qt)-Et - lct+l] + Et - IXt + 1 + gt T ct = Xxt + P Et - Int + I + ut 53 Wh en ut is serially uncorrelated, Xt= Ut and 7t= x2 Ut. 54 T o prove th at imperfect information leads to a reduction in w elfare, evaluate th e w elfare function w ith xI and ntI versus xt and ;t. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions Clarida, Gall, Gertler: T h e S cience of Monetary P olicy 1685 transmission of monetary policy. T h is case is of interest since much of th e available evidence suggests a lag of six to nine month s in th e effect of a sh ift in interest rates on output.55 T h e lag in th e effect on inflation is around a year and a h alf. S uppose, for example, th at it takes j periods for a sh ift in th e current interest rate to affect output and an- oth er k periods for an impact on infla- tion. In th e left side of equation (5.1) w ould appear th e j period ah ead fore- cast of th e output gap, and on th e righ t w ould be th e (suitably discounted) j + k period ah ead forecast of inflation. S vensson (1997a,b) h as emph asized th e practical importance of th is result for th e mech anics of inflation targeting (specifically, th e kind of inflation tar- geting th at th e th eory implies (see Re- sult 2 in section 3). A standard criticism of employing an inflation target is th at information about th e impact of current monetary policy on inflation is only available w ith a long lag. T h is informa- tion lag, it is argued, makes it impossi- ble to monitor policy performance. It is possible to circumvent th is problem, ac- cording to S vensson, by focusing in- stead on th e inflation forecast. T h e forecast is immediately available. It th us provides a quick w ay to judge th e course of policy. A caveat to th is argu- ment is th at to generate th e correct in- flation forecast, th e central bank must h ave a good structural model of th e economy.56 VA R-based forecasts are reasonable only if th e economy h as attained a stationary equilibrium. A traditional alternative to using th e target variable forecasts is to focus on th e beh avior of a variable th at is corre- lated w ith th e underlying targets but is instead observable and controllable. Broad monetary aggregates are th e best know n examples of intermediate tar- gets. If demand for a particular aggre- gate is stable, th en th is aggregate is likely to h ave a stable covariance w ith nominal GDP . In practice, h ow ever, ex- perience w ith monetary targeting h as not been successful. T h e U.S . and th e U.K., for example, attempted to regu- late th e grow th of money aggregates in th e early 1980s and th en quickly aban- doned th e policy after th e aggregates w ent h ayw ire.57 Financial innovation in each instance w as th e underlying cul- prit. Even in Germany, long considered a bastion of money targeting, th ere h ave been problems. Unstable movements in money demand h ave forced a retreat from strict money grow th targeting. A number of recent papers go furth er by arguing th at in practice Bundesbank policy looks more like inflation target- ing (as defined in Result 2) th an money targeting (Clarida and Gertler 1997; Bernanke and Mih ov 1997b). For similar reasons, policies th at tar- get oth er kinds of simple indicators, such as commodity prices or long term interest rates, h ave not been w idely em- ployed. A s Woodford (1994a) h as em- ph asized, th e correlation properties of th ese simple indicators w ith output and 55 Galf (1992), Ch ristiano, Eich enbaum, and Evans (1996), and Bernanke and Mih ov (1997a) document th e slow response of GDP to a policy sh ock, and th e even slow er response of prices. Bernanke and Gertler (1995) sh ow th at, w h ile th e overall response of output is sluggish , certain com- ponents of spending d-o respond quickly, such as h ousing and consumer durables. Inventories ad- just to reconcile th e gap betw een spending and output. 56 Bernanke and Woodford (1997) emph asize th e need to make structural forecasts. T h ey also raise some oth er related criticisms of using fore- cast-based targets, including th e possibility of in- determinacy under th is kind of policy rule. We discuss th is issue in section 7. 57 S ee Friedman and Kuttner (1996) for a de- tailed accounting of th e failure of monetary target- ing to take h old in th e U.S . S ee also Estrella and Mish kin (1996). On th e oth er h and, Feldstein and S tock (1997) argue th at, w ith periodic adjustment, a broad monetary aggregate can still be a useful intermediate target. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions 1686 Journal of Economic Literature, Vol. XXXVII (December 1999) inflation is likely to vary w ith ch anges in th e policy rule. In th e end, th ere is no sinmple substitute for employing a st-rtuctural model. T o summarize, w e h ave Result 9: With un perfect informa- tion, stemnmting eith er fro)m data prob- lemns or lags in th e effect of policy, th e optimal policy rules are th e certainty equivalent versions of th e perfect infor- m,ation. case. P olicy 'rules must be ex- pressed in, term-.s of th te forecasts of tar- get Variablles as opposed to th e ex post beh a vior. Using oi)servable intermediate target.s, such as broad money aggregates is a possibility, but experience suggests th at th ese indirect indicators are generally too uinstable to be use(d in practice. 5.1.2 T h e Instrutment Ch oice P roblem: T h e Interest Rate versus a N arrow Monetary A ggregate We now turn to th e issue of instru- ment ch oice. In practice, th e interest rate th at inajor central banks adjust is an overnigh t rate on interbank lending of fiunds to mieet reserve require- ments.58 T h ey control th is rate by ma- nipulating th e supply of bank reserves, i.e., th e quantity of h igh -pow ered money available for meeting bank re- serve requirements. T h e issue th at arises is w h eth er, from an operational standpoint, policy sh ould prescribe path is (or rules) for bank reserves or for interest rates. S uppose th at th e demand for bank reserves mit is given by59 m11t-pt = K yt- 1it + Vt (5.4) w h ere pt is th e price level and vt is a random disturbance to money demand. If vt is perfectly observable th en it does not matter w h eth er it or mt is employed as th e policy instrument. Given th e time path of it implied by th e optimal policy, it is possible to back out a time path for mt th at supports th is policy from equation (5.4). Matters ch ange if vt is not observ- able. With th e interest rate as th e in- strument, th e central bank lets th e money stock adjust to th e money de- mand *sh ock. T h ere is no impact of money demand sh ocks on output or in- flation because th e central bank per- fectly accommodates th em. With money targeting, th e reverse is true: th e inter- est rate and (possibly) output adjust to clear th e money market. A ssume for simplicity th at demand and cost push sh ocks are absent (i.e., gt = 0, Ut = 0), so th at th e only sh ock is th e innovation to money demand. T h en th e interest rate implied by a money supply instrument i71, is given by im = it + ( t (5.5) t 1 + p(P K + ) V w h ere it is th e rate th at w ould arise un- der interest rate targeting and Otis th e unexpected movement in money demand. T h e key point is th at money demand sh ocks can induce volatile beh avior of interest rates. T h is is particularly true if money demand is relatively interest in- elastic in th e sh ort run, as is th e case for bank reserves. T h is sh ort run volatil- ity in interest rates w ill th en feed into output volatility, via th e aggregate de- mand relation, equation (2.1). It is for th is reason th at in practice central banks use interbank lending rates as th e pol- icy instrument, an insigh t due originally to P oole (1970),60 Recent empirical 5D S ee Bernainke and Mih ov (1997a) for a discus- sion of Federal Reserve operating procedures and h ow th ey h ave ch anged over time. 59In 1th e optimizing IS /LM framew ork of sec- tion 2, it is possible to motivate th is specification of th e monev demand function from first princi- ples, assuming th at utility is separable in consump- tion and real money balances and th at consump- tion is th e only type of good (see, e.g., Woodford 1996). 60 P oole also argued th at if unobservable de- mand sh ocks w ere large relative to money demand sh ocks, th en it may be preferable to use a money This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions Clarida, Galz, Gertler: T h e S cience of Monetary P olicy 1687 w ork by Bernanke and Mih ov (1997a) confirms th at except for th e brief pe- riod of non-borrow ed reserve targeting under Volcker (1979: 10-1982: 10), th e Federal Reserve Board h as indeed treated th e Funds rate as th e policy in- strument. In summary, w e h ave Result 10: Large unobservable sh ocks to money demand produce h igh volatility of interest rates w h en a mone- tary aggregate is used as th e policy in- strument. It is largely for th is reason th at an interest rate instrument may be preferable. T h e analysis th us makes clear w h y th e new Federal Reserve Board model does not even both er to include a money ag- gregate of any form (see Flint Brayton et al. 1997). N arrow aggregates are not good policy instruments due to th e im- plied interest rate volatility. Broad ag- gregates are not good intermediate tar- gets because of th eir unstable relation w ith aggregate activity. 5.2 P olicy Conservatism: Model Uncertainty vs. Exploitation of Forw ard-Looking Beh avior In practice, central banks adjust in- terest rates more cautiously th an stan- dard models predict. P ut differently, optimal policies derived in a certainty equivalent environment generally pre- dict a much more variable path of inter- est rates th an is observed in practice. A n interesting illustration of th is point is Rotemberg and Woodford (1997) w h o estimate a model very similar to our baseline model, and th en compute an optimal interest rate policy. T h e h istori- cal interest rate displays much less vola- tility th an th e optimal interest rate. T h is finding is not uncommon. T h e FRB-US model also generates h igh in- terest rate volatility under an optimal rule. Because th is degree of volatility seems greater th an monetary policy makers seem w illing to tolerate in prac- tice, optimal rules are also computed w ith constraints on th e volatility of interest rate ch anges (see, e.g., Joh n Williams 1997).61 T h e tendency of th e Federal Reserve to adjust rates cautiously is generally re- ferred to as "interest rate smooth ing." T o be precise, as a number of auth ors h ave sh ow n, a monetary policy rule of th e follow ing form captures th e last tw enty or so years of data fairly w ell: it=(1-p)[c+ a t+ yxt] +pit_1+et (5.6) w h ere oc is a constant interpretable as th e steady state nominal interest rate62 and w h ere p E [0,1] is a parameter th at reflects th e degree of lagged depen- dence in th e interest rate.63 Interest rate smooth ing is present in distinct respects. First, th e estimated slope coefficients on inflation and th e output gap, ,3 and y, are typically smaller th an w h at th e optimal rule w ould suggest. S econd, th ere is typi- cally partial adjustment to movements in itt and xt, reflected by th e presence of th e lagged interest in th e fitted rule. T h at is, it is a w eigh ted average of some desired value th at depends on th e state economy (given by th e term [cc + 3tt + yXt]) and th e lagged interest rate, w h ere th e relative w eigh ts depend on th e smooth ing pa- rameter p. Estimates of p for quarterly data are typically on th e order of 0.8 or 0.9, w h ich suggests very slow adjustment supply instrument. With a money supply instru- ment, interest rates w ill naturally move in an off- setting direction in response to unobserved de- mand sh ocks (see Result 4). In practice, th e h igh variability of money demand sh ocks seems to dominate th e instrument ch oice, h ow ever. 61 A n alternative is to penalize large ch anges in th e nominal interest rate by including th e squared deviations of th e ch ange in th e interest rate (i.e, (it - it _)2) in th e function, as in Rudebusch and S vensson (1998). 62 Recall th at ;t represents deviations of infla- tion from its average (target) level. 63 S ee Rudebusch (1995), for example, for a dis- cussion of th e persistence in sh ort term interest rates. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions 1688 Journal of Economic Literature, Vol. XXXVII (December 1999) in practice. T h e existing th eory, by and large, does not readily account for w h y th e central bank sh ould adjust rates in such a sluggish fash ion. Indeed, understanding w h y central banks ch oose a smooth path of interest rates th an th eory w ould predict is an important unresolved issue. One impli- cation is th at th e standard certainty equivalence models may not adequately capture th e constraints policy-makers face in practice. A natural possibility is th at policy-makers know far less about th e w ay th e w orld w orks th an is presumed in simple policy experiments. In general, model uncertainty is a formidable problem. Ideally, one w ould like to take into account th at th e central bank is continually learning about th e economy as it adjusts its policy. P er- forming th is exercise in a clean w ay is beyond th e frontier of current know l- edge. T h ough , advances in computa- tional meth odology h ave allow ed some progress to be made w ith relatively simple framew orks.64 It is possible to illustrate h ow model uncertainty could in principle introduce at least some degree of policy caution. S uppose th e values of several parame- ters in th e model are random. T h e cen- tral bank know s th e distribution of th ese parameters but not th e realiza- tion. Wh en it adjusts policy, accord- ingly, it cannot be sure of th e impact on th e economy. A s originally demon- strated by William Brainard (1969), th is kind of uncertainty can introduce cau- tion in policy responses. In contrast to th e case of certainty-equivalence, policy actions now affect th e conditional vari- ance of inflation and output, as w ell as th e conditional mean. T o be concrete, suppose th at th e tw o parameters of th e model, th e interest elasticity in th e IS equation and th e slope coefficient on th e output gap are random variables, now given by pt = (p + ?t and by It = X + nt.65 A ssume furth er th at ?t and vlt are i.i.d random variables w ith zero means. T h e optimality condition for policy th en becomes: x a+ k2(y2 6 22~ + (cL + X2) rt (5.7) w h ere rt it-E{2tt+ 1 2t} is th e ex ante real interest rate. T h is condition leads to th e follow ing result: Result 11: P arameter uncertainty may reduce th e response of th e policy instrument to disturbances in th e econ- omy. It can th us motivate a smooth er path of th e interest rate th an th e cer- tainty equivalent policy implies. Comparing equations (5.1) and (5.7) reveals h ow parameter uncertainty re- duces policy activism. Under certainty equivalence, a rise in inflation above target requires th e central bank to raise interest rates to contract demand.66 With an uncertain slope coefficient on th e output gap in th e A S curve, h ow - ever, contraction of output below po- tential raises th e variability of inflation. T h is induces th e central bank to moder- ate th e contraction in demand, as re- flected by th e presence of th e term X2(a2 in th e coefficient on E{ 2t}. S imilarly, 64Wieland (1997) analyzes policy in a frame- w ork w h ere th e central bank h as to learn th e value of th e natural rate of unemployment (w h ich , in our analysis, corresponds to h aving to learn about potential GDP .) 65 We are assuming th at th e policy-maker know s th e first tw o moments of th e random parameters. It may be more plausible to argue th at th e policy- maker in fact h as little idea w h at th e true distri- bution looks like. S ee Onatski and S tock (1999) w h o analyze th e policy problem in th is kind of en- vironment using robust control meth ods. 66 It sh ould also be clear from equation (5.7) th at w ith parameter uncertainty th e interest rate no longer adjusts to perfectly offset demand sh ocks. S uppose, for example, th at th ere is a posi- tive demand sh ock. T h e interest rate goes up, but th e parameter uncertainty moderates th e extent of th e rise, relative to th e certainty equivalence case. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions Clarida, Galh , Gertler: T h e S cience of Monetary P olicy 1689 uncertainty about th e impact of an in- crease in th e interest rate on th e output gap moderates th e extent of adjustment in it. T h e second term on th e righ t side of equation (5.7) captures th is latter dampening effect. T h is simple form of model uncertainty th us may h elp explain th e relatively low variability of interest rates in th e data. One feature of interest rate smooth ing it does not appear to capture, h ow ever, is th e strong lagged dependence in th e interest rate. P ut differently, th e kind of parameter uncertainty w e h ave dis- cussed may explain w h y th e slope coef- ficients on inflation and th e output gap, cc and ,, are small relative to th e case of certainty equivalence. But it does not explain th e partial adjustment, given by th e dependence of it onit_ 1.67 Rotemberg and Woodford (1997) of- fer a novel explanation for th e lagged dependence th at is based on th e lever- age th at th is kind of adjustment rule may provide th e central bank over th e long term interest rate. T h e idea is th at lagged dependence in it permits th e central bank to manipulate long term rates, and h ence aggregate demand, w ith more modest movements in th e sh ort term rate th an w ould be oth erw ise be required. T h is kind of rule is th us desirable to th e extent th e central bank may care about avoiding excessive vola- tility in th e sh ort term interest rate in pursuing its stabilization goals. T o illustrate, consider th e special case of equation (5.6) w ith p = 1. In th is instance, th e difference in th e interest rate (it - it_ 1), as opposed to th e level, is a linear function of tt and xt. Under th e difference rule, th e expected future sh ort rate at t + i, Et{it + i}, is given by k Et{it+k}= EtIX(it+j - it+j- 1) +it [i' 1 (5.8) = EtjE [a + 1tt +j + Yxt +j] + it A ssume th at th e long-term rate depends on th e sum of expected sh ort rates over th e same h orizon, in keeping w ith th e ex- pectations h ypoth esis of th e term struc- ture. T h en, in comparison w ith th e level rule, th e difference rule increases th e re- sponsiveness of th e long term rate under th e feedback policy. S uppose for example th at, in reaction to a rise in inflation above target at time t, th e central bank raises it above its steady state value. Under th e difference rule th e increase in th e inter- est rate h as a persistent effect on th e path of th e expected sh ort rate, since Etitt+i4 depends additively on it. Furth er, if ch anges in inflation and output are persistent, th en th e path of expected sh ort rates w ill actually be rising, as equation (5.8) makes clear.68 T h e difference rule th us en- h ances th e countercyclical movement of th e long rate relative to th e movement of sh ort rate. Given th at aggregate demand depends on th e long rate, th is kind of rule th us enables th e central bank to 67 S ack (1997a,b) argues, noneth eless, th at pa- rameter uncertainty can explain th is ph enomenon if th e uncertainty of th e impact of th e interest rate on th e economy is based on th e ch ange in th e in- terest rate (it - it- ) as opposed to th e deviation from trend it, In th e former instance, ch anges in it raise th e conditional variability of output, w h ich induces th e central bank to keep it close to it -I. On th e oth er h and, it is not w ell understood h ow th e link betw een model uncertainty and policy conservatism is affected w h en th ere is active learning about th e economy. S ome results suggest th at learning sh ould induce active adjustments of th e policy instrument to facilitate estimating th e true model. S ee th e discussion in Wieland (1997), for example. A lso, it is possible to construct exam- ples w h ere parameter uncertainty leads to in- creased activism. S ee, for example, T h omas S ar- gent (1998). 68 On th e surface it appears th at th e interest rate migh t explode un der th e difference rule, since it w ill continue to increase so long as infla- tion is above target. How ever, th e rise in th e inter- est rate w ill dampen demand and inflation. In th e context of our model, it does so sufficiently to pre- clude explosive beh avior. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions 1690 Journal of Economic Literature, Vol. XXXVII (December 1999) stabilize th e economy w ith relatively modest movements in th e sh ort rate.69 Overall, Rotemberg and Woodford provide a plausible explanation for w h y central banks may w ant to introduce lagged dependence in th e interest rate. Wh eth er th is story can also account for th e empirically observed modest re- sponse of th e sh ort rate to inflation and th e output gap (i.e., th e low values of , and y, th e slope coefficients on tt and xt) remains to be seen. A noth er explanation for policy con- servatism and th e associated interest rate smooth ing includes fear of disrupt- ing financial markets (see, e.g., Good- friend 1991). S h arp unanticipated in- creases in interest rates can generate capital losses, particularly for commer- cial banks and oth er financial institu- tions th at may be exposed to interest rate risk. T h is consideration migh t ex- plain w h y th e Federal Reserve ch ose to raise rates only very gradually during 1994, th e tail end of a period of consid- erable financial distress (see, e.g., th e discussion in Joh n Campbell 1995). Dis- agreement among policy-makers is an- oth er explanation for slow adjustment of rates. N eith er of th ese alternative stories h ave been w ell developed, h ow ever. In general, understanding w h y interest rate smooth ing occurs, in practice is an important unresolved issue. 5.3 N on-S mooth P references and Opportunism A noth er aspect of policy th at h as re- ceived considerable attention involves th e process of disinflation. In th e base- line model, if inflation is above target, it is alw ays optimal to tigh ten monetary policy to gradually bring inflation back to th e optimum (see Result 2 in S ection 3). During h is tenure at th e Federal Re- serve Board, h ow ever, Blinder proposed th e follow ing alternative: If inflation is above but near th e optimum, policy sh ould not contract demand. Rath er, it sh ould take an "opportunistic" ap- proach . Rough ly speaking, being oppor- tunistic boils dow n to w aiting until ach ieving th e inflation target could be done at th e least cost in terms of incre- mental output reduction. Blinder's original concept w as vague as to th e de- tails. Recent w ork by research ers at th e Federal Reserve Board h as filled in a number of th e missing pieces. A th anasios Orph anides and David Wilcox (1996) sh ow th at it is possible to rationalize someth ing like opportunistic policy by making a small adjustment of th e policy objective function. In par- ticular, suppose th at policy-makers care quite a lot about small departures of output from target, at least relative to small departures of inflation. A n exam- ple of an objective function th at capture th is ph enomenon is given by I H0 max- - Et. LX i(Xt | xt 2 + (5.9) 2 [i= With th is objective function, th e opti- mality condition for policy becomes: xt =0, if IT t< cc X (5.10) Intl = , oth erw ise T h us, if inflation is w ith in units of th e target, th e optimal policy is to sim- ply stabilize output. Oth erw ise, policy sh ould keep inflation at most units from target and th en w ait for favorable supply sh ocks th at move it closer to tar- get (e.g., favorable movements in th e cost push sh ock ut). In th is respect th e 69 T h e idea th at th e central bank sh ould pursue a partial adjustment rule to exploit th e depen- dence of demand on future policy is reminiscent of th e globally optimal policy under commitment (see section 4.2.2). Indeed, Woodford (1998) makes th is connection formally. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions Clarida, Gali, Gertler: T h e S cience of Monetary P olicy 1691 policy is opportunistic. A better term for it, h ow ever, migh t be "inflation zone targeting" (Bernanke and Mish kin 1997). Wh at th e policy really amounts to is keeping inflation w ith a certain range, as opposed to trying to move it to an exact target. Variations on th is th eme allow for preferences th at generate an inflation zone target, but th en h as policy trade off betw een inflation and output goals w h en inflation is outside th e target zone. Or- ph anides, David S mall, Volcker Wieland and Wilcox (1997) (OS WW) provide an example of th is more general setup. It is important to emph asize, th ough , th at opportunistic policy beh avior th at is distinct from th e gradualism of th e baseline model only arises if cost push factors are present in inflation. T h is is true because only w ith cost push infla- tion present does a trade-off betw een output and inflation emerge (see Result 1). Indeed, OS WW sh ow th at opportun- istic policy rules are equivalent to con- ventional gradualist rules in th e pres- ence of demand sh ocks, but differ w h en th ere are supply sh ocks.70 In summary, w e h ave Result 12: If th ere is more cost asso- ciated w ith small departures of output from target th an w ith small departures of inflation, th en an opportunistic ap- proach to disinflation may be optimal. T h is policy, furth er, is equivalent to targeting inflation around a zone as opposed to a particular value. 6. Implications of Endogenous Inflation and Output P ersistence With in our baseline model, th e dy- namics of output and inflation are due entirely to exogenous force processes. We now consider an alternative frame- w ork th at allow s for endogenous persis- tence in output and inflation. Our pur- pose is to sh ow th at th e results derived in th e baseline framew ork extend to th is more general setting. In th is regard, w e sh ow th at our results are not specific to th e particular bench mark model w e em- ployed, but instead h old across a rea- sonably broad class of models th at are used for applied macroeconomic analy- sis. T h e major difference is th at w ith endogenous persistence in inflation, th e equilibrium feedback monetary policy now influences th e speed of convergence of inflation to its target. Consider th e follow ing generaliza- tions of th e IS and aggregate supply curves: Xt= -(p[it - Et2tt+ i] + 0xt-i + (1 - e)Etxt + I + gt (6.1) 7tt = X Xt + ? 7t - 1 + (1 - )P Etnt + I + Ut (6.2) Equation (6.1) incorporates th e lagged output gap in th e IS curve. Equation (6.2) adds lagged inflation to th e aggre- gate supply curve. T h e parameters 0 and ' index th e influence of lagged versus ex- pected future variables. A s a result th e model nests some important special cases. With 0 = 0 and ? = 0, w e recover th e baseline model. Conversely, w ith 0 = 1 and ? = 1, th e model becomes (approximately) th e backw ard-looking framew ork th at S vensson (1997a,b) and Ball (1997) h ave used to analyze mone- tary policy. For simplicity w e assume th at th e disturbances gt and ut are serially uncorrelated (i.e., w e set ,u and p in equation (2.3) and (2.4) equal to zero). T h is simple formulation does not allow for delays in th e effect of policy, but w e sh ow later th at it is easy to amend th e analysis to incorporate delayed policy effects. A s w e noted earlier, virtually all th e 70 For an alternative description of th e oppor- tunistic approach , see Bomfin and Rudebusch (1997). T h ese auth ors emph asize th e ratch eting dow n of inflation and, in particular, explore th e role of imperfect credibility. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions 1692 Journal of Economic Literature, Vol. XXXVII (December 1999) major applied macroeconomic models allow for some form of lagged depen- dence in output and inflation. T h e pri- mary justification is empirical.71 By ap- pealing to some form of adjustment costs, it may be feasible to explicitly motivate th e appearance of xt -1 w ith in th e IS curve. Motivating th e appearance of lagged inflation in th e aggregate sup- ply curve, h ow ever, is a more formida- ble ch allenge.72 S ome framew orks do so by effectively appealing to costs of ch anging th e rate of inflation.73 T h is as- sumption, th ough , is clearly unattrac- tive. In th e spirit of robustness, h ow - ever, it is important to understand th e implications of lagged dependence. T h is is particularly true given th e empirical appeal of th is formulation. We begin w ith th e case of discretion, and th en later describe briefly h ow th e results are affected w h en th e central bank can make credible promises.74 A n analytical solution is not available, ex- cept in th e polar cases of ? = 0 and ? = 1. It is, h ow ever, possible to provide an in- tuitive description of th e optimum. Let as be a parameter th at measures th e se- rial dependence of inflation in th e reduced form. T h en th e optimality condition th at governs policy is given by: Xt =-[2t + E P kEt2tt+k] (6.3) =- oeX(1-J3a7)t (6.4) W1( - ,P an) c w ith 2tt=a tct- +auut (6.5) and O < as < 1 With inertia present, adjustments in current monetary policy affect future time path of inflation. A s consequence, policy now responds not only to current inflation but also to forecasts of infla- tion into th e indefinite future. How much depends positively on a,,, w h ich measures th e degree of inflationary persistence. T h e coefficients as and au are func- tions of th e underlying parameters (oc,k,p,?).75 T h e former, as, is key, since it measures th e speed of convergence to inflation under th e optimal policy. It is possible to sh ow th at th is parameter lies betw een zero and unity, implying con- vergence. T h e magnitude of a,, depends positively on th e degree of inflation in- ertia ?. In th e baseline case of no infla- tion inertia, ? = 0, implying as = 0. a,, 71 For an empirical justification for including lagged dependent variables, see Fuh rer (1996). 72 It is possible to motivate a dependency of cur- rent inflation on lagged inflation by appealing to adaptive expectations (e.g., suppose Et - lt= Kst- 1). Indeed, th is is th e traditional approach (see th e discussion in Blanch ard 1997). T h e issue th en becomes motivating th e assumption of adap- tive expectations. 73 S ee, for example, Fuh rer and Moore (1995a,b) and Brayton, Levin, T yron, and Williams (1997). Galf and Gertler (forth coming) criticize th e existing empirical literature on inflation dy- namics, and provide new evidence w h ich suggests th at (2.2) is a good first approximation to th e data. 74A s in section 3, w e restrict attention to Markov perfect equilibria. In th is case, h ow ever, w e must take into account th at inflation is an en- dogenous state variable. In any stationary equilib- rium, th erefore, expected inflation w ill depend on lagged inflation. Wh at th e policy maker takes as given, accordingly, is not th e level of expected in- flation, but rath er h ow private sector expectations of inflation tomorrow respond to movements in in- flation today. S imply put, to solve for th e equilib- rium under discretion, w e assume th at private sec- tor forecast of ;t + 1 takes th e form v=;t + vuut, w h ere v. and vu are arbitrary constants th at th e policy-maker takes as given. In th e rational expec- tations equilibrium v. and v.U equal th e true funda- mental parameters in th e reduced form inflation, a.c and aUl. 75T o obtain solutions for an and atu, substitute th e optimality condition xt= - (l ct and th e conjectured solution for ntt, (6.5), into th e ag- gregate supply curve. T h en use th e meth ods of undetermined coefficients to solve for an and au. T h e equation for a, is a cubic. T h e solution is th e unique value betw een zero and unity, w h ich corre- sponds to th e unique stable root. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions Clarida, Galt', Gertler: T h e S cience of Monetary P olicy 1693 0.9 0.8- 0=99 0.7 - 0.6 - _ _- 0.5 -~~~~~~~ - - - ~ ~ ~ 0=. 0.4 - 0.31, / 0.2 - 0 0.1 o o6 cs ci cs c6 c6 c6 c6 t 4 Figure 2. ca for different values of Q also depends negatively on th e relative cost of inflation, measured by 1/ac. A s in th e baseline case, if th e distaste for in- flation is h igh (ac is low ), th e optimal policy aggressively contracts demand w h enever inflation is above target: With endogenous persistence, th is contrac- tion not only reduces inflation but also increases th e speed of convergence to target. Figure 2 illustrates th e relation betw een an and ac for th ree different values of o: o = 0.01 (low inertia), o = 0.5 (medium) and o = 0.99 (h igh ). Combining (6.3) w ith (6.1) yields th e implied optimal interest rate rule: it =yEtnt + I + y-xt - +-gt (6.6) w ith = (1 - a) T paa( - Et2tt + 1 = air)t Most of th e qualitative results ob- tained in th e baseline case extend to th is more general setting. A s in th e baseline case, th e policy-maker faces a sh ort-run trade-off betw een output and inflation (Result 1). T h e effect of infla- tion inertia is to make th is trade-off less favorable. Equation (6.3) sh ow s th at relative to th e baseline case of o = 0, th e optimal policy requires a more aggres- sive response to any burst of inflation. T h e problem is th at any inflation not eliminated today persists into th e fu- ture, potentially requiring more output contraction. Figure 3 illustrates h ow th e trade-off becomes less favorable in th is case by plotting th e efficient policy frontier for th e th ree bench mark values of o. In addition, since 0 < a, < 1, th e op- timal policy calls for gradual adjustment of inflation to target (Result 2). With o > 0, furth er, extreme inflation target- ing is only optimal if a = 0, as equation (6.3) and Figure 2 suggest. From th e interest rate rule given by This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions 1694 Journal of Economic Literature, Vol. XXXVII (December 1999) 3.5 - 3 - 2.5 - o 1.5- 0.5- 0 0 1 2 3 4 5 sd(inflation) 3.5, 3 - i =.5 O25- iz 2 -\ o 1.5 - \ 0 7 0 1 2 3 4 5 sd(inflation) 3.5 - 3 - i =.99 2.5- iz 2 -\ o 1.5- 1- 0.5- 0 0 1 2 3 4 5 sd(inflation) Figure 3. Efficient P olicy Frontier for Different Values of 4 equation (6.6) it is apparent th at th e co- efficient on expected inflation exceeds unity, implying th at th e ex ante real rate must rise in response to h igh er ex- pected inflation (Result 3). Finally, th e interest rate sh ould also adjust to per- fectly offset demand sh ocks, but sh ould not respond to movements in potential output (Result 4.) One interesting dif- ference in th is case is th at th e interest rate responds to th e lagged output gap, since th is variable now enters th e IS curve. T h us, th e optimal interest rate rule now resembles th e simple gap rules th at h ave been discussed in th e litera- ture. We return to th is point later. In summary, w e h ave Result 13: Results 1 th rough 4 th at describe optimal monetary policy under discretion w ith in th e baseline model also apply in th e case w ith endogenous output and inflation persistence. In addition to allow ing for lagged de- pendence in output and inflation, th ere is also strong empirical justification for incorporating delays in th e effect of policy. It is straigh tforw ard to extend th e analysis to include th is real w orld feature. S uppose, follow ing S vensson (1997a,b) and Ball (1997), th at th ere is a one-period delay in th e effect of th e real interest rate on th e output gap and, in turn, a one-period delay in th e effect of th e output gap on inflation. T h en th e optimality condition becomes76 Et{xt+i} = - (l Et{tt+ 2} (6.7) w h ere th e parameter al measures th e se- rial dependence in inflation for th is case. It h as qualitatively similar properties to an in equation (6.5), w ith 0 < al < 1. T h e left side of (6.7) reflects th e one-period delay in th e impact of policy on output, 76 In th is case, th e IS curve is given by xt = -(p[it-l-Et-Iit]+Oxt-1+(1-O)Et-lxt+i+gt and th e aggregate supply curve is given by ;T t= XXt - 1 + 0rnt - 1 + (1 - )Etnt + 1 + Ut. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions Clarida, Call, Gertler: T h e S cience of Monetary P olicy 1695 and th e righ t side reflects th e tw o-period delay on inflation. Due to th e delayed impact of policy, th e central bank takes both th e output gap at t, Xt, and th e forecast of inflation at t + 1, Et{itt + 1}, as predetermined from th e vantage of time t. T h e rest of th e solution may th us be expressed in terms of th ese predetermined variables: EtInt + 2} = a' Et{It + 1} (6.8) it = yg Etnt + I + yx xt (6.9) w ith : 5, 1+ >1 T h e solution closely resembles th e case w ith out delay. A ny differences just reflect th e lagged influence of policy in th is environment. T h e nominal rate still adjusts more th an one-for-one w ith ex- pected inflation. Due to th e lag struc- ture, th ough , it adjusts to th e current output gap, as opposed to one from th e previous period. We conclude th is section w ith brief discussion of th e gains from commit- ment. It is possible to sh ow th at, as in th e baseline model, th e policy rule un- der commitment resembles th e rule un- der discretion th at w ould obtain if th e policy-maker assigned a h igh er relative cost to inflation (low er value of ox ) th an th e true social cost. Because inflation inertia is endogenous in th is case, th e optimal policy w ith commitment im- plies a faster transition of inflation to th e optimum relative to w h at occurs un- der discretion. T h is can be seen by not- ing th at th e parameter w h ich governs th e speed of convergence of inflation, an, is decreasing in th e relative cost of inflation 1/cc (see Figure 4).77 S imply put, disinflations w ill be sw ifter th an oth erw ise if credible commitment is possible eith er directly or indirectly by installing a conservative central bank ch air. 7. S imple Rules for Monetary P olicy We next discuss some normative and positive aspects of simple feedback rules for th e interest rate th at h ave been discussed in th e literature. We th en discuss h ow th ese instrument-based rules are related to simple rules for tar- gets th at h ave been recently proposed, including inflation targeting and nomi- nal GDP targeting. Finally, w e conclude w ith a brief discussion of th e issue of possible indeterminacy of interest rate rules. 7.1 S imple Interest Rate Rules T aylor (1993a) ignited th e discussion of simple interest rate rules.78 He pro- posed a feedback policy of th e follow ing form: it* = a + 7n (nt - n) + 7u Xt (7.1) w ith aC=F +s yx > 1, YX > O w h ere i* is th e target interest rate th e feedback rule defines, ji is th e target in- flation rate, and r- is th e long-run equi- librium real interest rate.79 A lso, w e now express all variables in levels, as opposed to deviations from trend. A number of oth er research ers h ave considered rules like (7.1) (see, e.g., Henderson and Mckibbon 1993). T ay- lor's contribution is to spell out th e nor- mative and positive implications. On 77N ote th at th e speed of convergence of infla- tion is decreasing in ar. 78 McCallum (1988) proposed a simple rule for th e monetary base. T h e rule is less popular in pol- icy circles due to th e implied interest rate volatil- ity (see Result 9). McCallum (1997) argues, h ow - ever, th at th e concern about interest rate volatility is not w ell understood, a point w ith w h ich w e agree. 79T h e inflation rate T aylor uses is actually th e rate over th e previous year (as opposed to th e pre- vious quarter). This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions 1696 journal of Economic Literature, Vol. XXX VII (December 1999) 18-I 16- 14 - 12- / ~~ ,IEF F.RA T E 10 I g 8 u . 6 - , 4 - %~~~- 10 1 - 2 - ' IN FLA T ION 0- IIIIIIIIli 111IIIIIIIIIIIIII IIIIIIIIII I I ) CO -l COI -0 ~C O C) - Ci "I CO 1- CO CO -- COI It ~C - CO -l COI -0 ~C ~C t~- t- r- tr- tr- t- 00 0000 00) 00) 00) 00) O 0 m m m Figure 4. T h e Federal Funds Rate and th e Inflation Rate th e normative side, th e rule is consis- tent w ith th e main principles for opti- mal policy th at w e h ave described. It calls for gradual adjustment of inflation to its target (see Result 2). S pecifically, it h as th e nominal rate adjust more th an one-for-one w ith th e inflation rate. T o th e extent lagged inflation is a good predictor of future inflation, th e rule th us h as real rates adjusting to engineer inflation back to target (see Result 3). Finally, note th at th e interest rate re- sponds to th e output gap as opposed to th e level of output. T h us, in at least an approximate sense, th e rule calls for a countercyclical response to demand sh ocks and accommodation of sh ocks to potential GDP th at do not affect th e output gap (see Result 4). On th e positive side, T aylor sh ow ed th at w ith certain parameter values, th e rule provides a reasonably good descrip- tion of policy over th e period 1987-92. T h ese are: yll= 1.5, y.= 0.5, =2, and r = 2. T aylor used informal judgement to pick th em. A n interesting question is w h eth er a formal meth odology w ould yield someth ing different. In th is spirit, Clarida, Galf, and Gertler (forth coming) estimate a simple rule for U.S . monetary policy, and consider h ow th is rule h as evolved over time. T h e specific formulation is a "forw ard look- ing" version of th e simple T aylor rule: it = cc + ya (Etnt + I - T ) + y xt (7.2) Under th is rule, policy responds to expected inflation as opposed to lagged inflation. In th is respect, th e formula- tion is consistent w ith th e optimal rules derived for both th e baseline and h y- brid models (see equations 3.6 and 6.6). This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions Clarida, Galt', Gertler: T h e S cience of Monetary P olicy 1697 T A BLE 1 ES T IMA T ES OF P OLICY REA CT ION FUN CT ION Y 7r. p P re-Volcker 0.83 0.27 0.68 (0.07) (0.08) (0.05) Volcker-Greenspan 2.15 0.93 0.79 (0.40) (0.42) (0.04) A noth er virtue is th at th is formulation nests th e simple T aylor rule as a special case. If eith er inflation or a linear com- bination of lagged inflation and th e out- put gap is a sufficient statistic for future inflation, th en th e specification col- lapses to th e T aylor rule. Because of th e Federal Reserve's ten- dency to smooth interest rate adjust- ments (see th e discussion in section 5), a static relation like equation (7.2) can- not capture th e serial correlation pres- ent in th e data. We th us allow for th e possibility of partial adjustment to th e target rate, according to: it = pit- 1+(I- p)it* (7.3) w h ere p is a parameter th at measures th e degree of interest rate smooth ing. We estimate different rules for th e pre-Volcker (1960: 1-79: 2) and Volcker- Greenspan (1979: 3-96: 4). We do so be- cause it is w idely believed th at U.S . monetary policy took an important turn for th e better w ith th e appointment of P aul Volcker as Fed Ch airman (see Friedman and Kuttner 1996 and Gertler 1996). A mong oth er th ings, th is period marks th e beginning of an apparently successful and long-lasting disinflation. We find th at th e simple rule given by equation (7.2) does a good job of ch ar- acterizing policy in th e Volcker-Green- span era. Furth er, it adh eres to th e guidelines for good policy th at w e h ave establish ed. T h e estimated pre-Volcker rule violates th ese guidelines. S pecifi- cally, th e parameter estimates along w ith standard errors are given by T able 1.80 T h e key lesson involves th e parame- ter yn, th e coefficient on th e inflation gap. T h e estimate for th e pre-Volcker rule is significantly less th an unity. T h is suggests th at monetary policy over th is period w as accommodating increases in expected inflation, in clear violation of th e guidelines suggested by Results 2 and 3. For th e post-1979 rule th e esti- mate is significantly above unity. It th us incorporates th e implicit inflation tar- geting feature th at w e h ave argued is a critical feature of good monetary policy management. It is also true th at in th e Volcker-Greenspan era th e Federal Re- serve w as only responding to th e output gap to th e extent it h ad predictive pow er for inflation: 81 T h e estimated co- efficient on th e output gap, yx, is not significantly different from zero. P re 1979: 4 it is positive and significant. T h is outcome is consistent w ith th e conven- tional view th at pre-1979, th e Federal 80T h e estimates of th e parameters in equation (7.2) are obtained by using an instrumental vari- ables procedure based on Generalized Meth ods of Moments (GMM). S ee Clarida, Galf, and Gertler (forth coming) for details. T h e specific numbers reported h ere are based on a version of th is policy reaction function th at h as th e Funds rate respond to expected inflation a year ah ead and th e current output gap (reported in T able 2 of th at paper). T h e results, h ow ever, are robust to reasonable variations in th e h orizons for th e gap variables. 81 In particular, th e output gap enters th e in- strument set for expecte in ation. T h us, th e coefficent y. reflects th e influence of th e output gap on th e interest rate th at is independent o its predictive pow er for inflation. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions 1698 Journal of Economic Literature, Vol. XXXVII (December 1999) 25 . | F.F. RA T E 20 - T A RGET (FWD) 15 - 10 'I II'I 5 -~~~~~~~ 5 # Co -.t I cq Co t -- c* Co t - c Co t - c* cO t - cq cO t i cq m sb oo o - cA cr 000 o -o i c6 r6 c 6 r o o66 i c>i c6 6 "6 Q0 Q0 0 ts- t- t- t t- t- t- t- 00 00 00 00 00 00 00 00 oo oo oo oo C Figure 5. T arget Based On Estimated P ost-October '79 Rule vs. A ctual Funds Rate Reserve w as relatively more focused on output stabilization and less focused on inflation. T h e finding th at th e Fed responded differently to inflation in th e tw o eras is apparent from inspection of th e data. Figure 4 plots th e Federal Funds rate and th e rate of CP I inflation from 1965 to th e present. T h e graph sh ow s a clear break in th e Funds rate process around 1979.82 During most of th e 1970s, th e ex post real rate w as zero or negative. A fter 1979 it becomes positive. Wh ile many factors influence th e real rate, th e tigh t monetary policy engineered by P aul Volcker surely provides th e most logical explanation for th is initial run-up. Figure 5 illustrates th e policy ch ange by plotting th e estimated target value of th e interest rate under th e Volcker- Greenspan rule over th e entire sample period. T h e target rule does a good job of capturing th e broad movements in th e Funds rate for th e second h alf of th e sample, for w h ich it w as estimated. For th e pre-Volcker period, matters are different. T h e target (generated by th e estimated Volcker-Greenspan rule) is systematically w ell above th e h istorical series. In th is concrete respect, policy w as far less aggressive in figh ting inflation in th e earlier period.83 Figure 6 compares th e ability of th e forw ard and backw ard looking (T aylor) target rules to explain th e post 1979 data. T h ough w e find th at th e data re- jects th e backw ard looking rule in favor of th e forw ard looking one,84 th e tw o do a rough ly similar job of accounting for th e beh avior of th e Funds rate. T h is oc- curs probably because, w ith U.S . data, 82 Huizinga and Mish kin (1986) present formal evidence of a structural break at th is time. 83 S ome but not nearly all th e difference be- tw een rates pre-1979 and th e target values under a post-1979 rule could be accounted for by a secular ch ange in th e real rate. 84 S ee Clarida, Gali, and Gertler (1998). This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions Clarida, Galtl, Gertler: T h e S cience of Monetary P olicy 1699 25 F.F. RA T E 20 - ...T A RGET (BCKWD) - - - - T A RGET (FWD) 15- Ito 5- 't co C\1 _ 't co c\ i t co C1 H t co cq 't co c t co c\ _ c 6 -4 c>i ci c5 L h c.o r- o o6 o6 o 6 q - c j ci 6 P c t~- 00) 00) 00) 00) 00) 00 00 00 00 00 00 00 00 F w vs B w L k Rules Figure 6. T argets from Forw ard vs. Backw ard Looking Rules not much besides lagged inflation is useful for predicting future inflation. Finally, it is interesting to observe th at th e oth er major central banks, th e Bundesbank and th e Bank of Japan, h ave beh aved very similarly in th e post- 1979 era. In Clarida, Gall, and Gertler (1998), w e estimate our specification for th ese central banks. T h e estimated parameters in each case are quite close to th ose obtained for th e Federal Re- serve during th e Volcker-Greenspan period. T h us, good policy management appears to h ave been a global ph enome- non. P erh aps th is is not surprising since th e successful disinflation h as also been a w orld-w ide event. 7.2 S imple T arget Rules T h ere h ave also been proposed sim- ple rules for targets, as opposed to in- struments. Of th ese proposed policies, inflation targeting h as received by far th e most attention (see Bernanke and Mish kin 1997 for a recent survey). In- deed a number of central banks, most notably th e Bank of England, h ave re- cently adopted formal inflation targets (see, e.g., A ndrew Haldane 1996). In one sense, inflation targeting in- volves noth ing more th an pursuing th e kind of gradualist policy th at our opti- mal policy calculation implies (see Re- sult 2). Indeed, all th e leading real- w orld proposals call for gradual convergence of inflation to target. N one recommend trying to h it th e inflation target continuously, w h ich is consistent w ith our analysis. In th is respect, th e rule w e estimate for th e period is per- fectly consistent w ith inflation targeting. T h e rationale for inflation targeting, w e th ink, is tw ofold. T h e first is simply to guarantee th at monetary policy avoids th e mistakes of th e pre-Volcker era by identifying a clear nominal an- ch or for policy. (A fter all, A lan Green- span w ill not be around forever). T h e This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions 1700 Journal of Economic Literature, Vol. XXXVII (December 1999) inflation target is in effect th e nominal anch or. S ince th e anch or is directly in terms of inflation, it avoids th e poten- tially instability problems associated w ith alternatives such as money grow th th at are only indirectly linked to infla- tion. For example, if th ere are large sh ocks to money demand, th en a money grow th target may fail precisely to pin dow n th e equilibrium inflation rate. T h e second rationale h as to do w ith credibility and commitment. We h ave seen th at it is in general optimal for policy-makers to place a h igh er w eigh t on th e costs of inflation th an th e true social loss function suggests (see Re- sults 6 and 7). T h e focus on inflation targets may be view ed as a w ay to instill a h igh er effective w eigh t on inflation in th e policy ch oice. P rice level targeting is anoth er type of simple rule th at h as been discussed in th e literature. T h is policy, w h ich may be th ough t of as a more extreme version of inflation targeting, h as not received much support among policy-makers and applied economists. T h ere are several problems: First, if th e price level over- sh oots its target, th e central bank may h ave to contract economic activity in or- der to return th e price level to its goal. T h at is, inflation above th e amount im- plied by th e price level target must be follow ed by inflation below th is desired amount in order to return th e target. Under inflation targeting, bygones are bygones: oversh ooting of inflation in one year does not require forcing infla- tion below target in th e follow ing year. S econd, th e source of positive drift in th e price level maybe measurement er- ror (see th e discussion in section 2.) It w ould be unfortunate to h ave measure- ment error induce tigh tening of mone- tary policy. T h ird, as McCallum (1997b) sh ow s, th e net reduction in price uncer- tainty under a price level target rule, may be small relative th at obtained un- der an inflation targeting policy. For all th ese reasons, it is perh aps not surpris- ing th at no major central bank h as adopted a price level target. A noth er candidate variable for target- ing is nominal GDP . T h is approach h as also received less attention in th e re- cent literature, h ow ever. One problem is th at if th ere are sh ifts in th e trend grow th of real GDP , th e rule does not provide a precise nominal anch or. A n- oth er problem, emph asized by Ball (1997), is th at th e policy may be overly restrictive. In th e h ybrid model of sec- tion 5, for example, th e optimal policy in general h as th e interest rate adjust to some linear combination of expected in- flation, th e output gap and demand dis- turbances. T h e w eigh ts depend upon th e underlying structural parameters of th e model. Under nominal GDP target- ing, th e central bank adjusts th e inter- est rate to th e sum of inflation and real GDP grow th . It th us arbitrarily applies an equal w eigh t to each component of nominal GDP . High nominal GDP grow th , furth er, could occur w h en th e economy is recovering from a recession and is still w ell below full capacity. A rule th at calls for raising interest rates in response to above-target nominal GDP grow th in th ese circumstances could stifle th e recovery.85 7.3 Indeterminacy under Interest Rate Rules One criticism of simple interest rate rules is th at, under certain circum- stances, th ey may induce instability. T h at is, in many models th ere may not be a determinate equilibrium under particular parametrizations of th e policy 85 S ee Ball (1997) and S vensson (1997b) for ex- plicit exam les of h ow nominal GDP targeting could prosuce adverse outcomes. McCallum (1997c), h ow ever, argues th at th ese results are sensitive to th e use of a backw ard-looking P h illips curve. For th e case in favor of nominal GDP tar- geting, see Hall and Mankiw (1994). This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions Clarida, Galtl, Gertler: T h e S cience of Monetary P olicy 1701 rule. In a classic paper, T h omas S argent and N eil Wallace (1975), illustrated h ow nominal indeterminacy may arise if prices are perfectly flexible. Under an interest rate rule th e equilibrium pins dow n th e level of real money balances. How ever, th ere are an infinite number of combinations of th e nominal money stock and th e price level th at satisfy th is equilibrium condition.86 In th is respect, th e interest rate rule produces nominal indeterminacy.87 Wh en th ere is sluggish price adjust- ment, th e problem of nominal indeter- minacy vanish es. Last period's price level effectively serves a nominal an- ch or. S imple interest rate rules th us do not produce price level indeterminacy in th e framew orks w e h ave analyzed. More generally, since th ere is little rea- son to believe th at prices are perfectly flexible, th e issue of nominal indetermi- nacy does not seem important in prac- tice. On th e oth er h and, th ere is poten- tially a problem of real indeterminacy in th e case of price stickiness, as Wil- liam Kerr and Robert King (1996), Ber- nanke and Woodford (1997) and Clarida, Galf and Gertler (forth coming) h ave re- cently emph asized.88 T w o types of inde- terminacy are possible. First, if in re- sponse to a rise in expected inflation, th e nominal rate does not increase suf- ficiently to raise th e real rate, th en self- fulfilling bursts of inflation and output are possible. A rise in expected infla- tion, leads to a fall in real rates th at, in turn, fuels th e boom. Indeed, th e mone- tary policy rule th at Clarida, Gali, and Gertler (forth coming) estimate for th e pre-Volcker period permits exactly th is kind of sunspot beh avior. T h e lesson h ere is simply th at a good monetary pol- icy rule sh ould not accommodate rise in expected inflation. It sh ould instead pursue th e implicit kind of inflation targeting th at w e h ave been emph asiz- ing. T h is boils dow n to raising nominal rates sufficiently to increase real rates w h enever expected inflation goes up. A s Bernanke and Woodford (1998) emph asize, indeterminacy is also possi- ble if th e rule calls for an overly aggres- sive response of interest rates to move- ments in expected inflation. In th is instance, th ere is a "policy overkill" ef- fect th at emerges th at may result in an oscillating equilibrium. Clarida, Galf and Gertler (forth coming) sh ow , h ow - ever, th e magnitude of th e policy re- sponse required to generate indetermi- nacy of th is type greatly exceeds th e estimates obtained in practice. T h is po- tential indeterminacy h ow ever does suggest anoth er reason w h y a gradual approach to meeting an inflation target may be desirable. 8. Concluding Remarks We conclude by describing several areas w h ere future research w ould be quite useful: (1) It is alw ays th e case th at more know ledge of th e w ay th e macro- economy w orks can improve th e perfor- mance of monetary policy. P articularly critical, h ow ever, is a better understanding 86 McCallum (1997), h ow ever, argues th at th e price level is in fact determined in th is kind of environment. 87A recent literature sh ow s th at th e govern- ment's intertemporal budget constraint may re- store uniqueness under an interest rule, even in an environment w ith flexible prices. Wh at is criti- cal is w h eth er th e interest on th e debt is financed by taxes or money creation. S ee, for example, Woodford (1994), S ims (1994), and Leeper (1991). 88T h ese papers focus on local indeterminacy. S ee Jess Belih abib, S teph anie S ch midt-Groh e, and Martin Uribe (1998) for a discussion of global in- determinacy. T o avoid global indeterminacy, th e central bank may h ave to commit to deviate from a simple interest rate rule if th e economy w ere to get sufficiently off track. T h is th reat to deviate can be stabilizing, much th e w ay off th e equilibrium path th reats induce uniqueness in game th eory. Because th e th reat is sufficient to preclude inde- terminate beh avior, furth er, it may never h ave to be implemented in practice. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions 1702 Journal of Economic Literature, Vol. XXXVII (December 1999) of th e determinants of inflation. A s w e h ave emph asized, th e output/inflation trade-off is h igh ly sensitive to both th e degree and nature of th e persistence in inflation. A s a consequence, so too is th e speed at w h ich monetary policy sh ould try to reach th e optimal inflation rate. Rationalizing th e observed persis- tence in inflation is th us a h igh priority. Work by Gali and Gertler (forth coming) and A rgia S bordone (1998) suggests th at th e sh ort-run aggregate supply curve employed in our baseline model may provide a reasonable approximation of reality, so long as real marginal cost (specifically real unit labor costs) is used as th e relevant real sector forcing vari- able instead of th e output gap, as th e th eory suggests. Gali and Gertler (forth - coming) argue furth er th at persistence in inflation may be related to sluggish adjustment of unit labor costs vis-a-vis movements in output. S orting out th is issue w ill h ave important repercussions for monetary policy. (2) Our analysis of monetary policy, as in much of th e literature, w as re- stricted to closed economy models. Ex- tensions to open economy framew orks are likely to provide new insigh ts on th e desirability of alternative monetary pol- icy rules, and raise a number of issues of great interest, including: th e ch oice of exch ange rate regime, th e potential benefits from monetary policy coordi- nation, th e optimal response to sh ocks originating abroad, and consumer price index versus domestic inflation target- ing. Recent w ork by Ball (1998), S vens- son (1998), and Monacelli (1999) along th ese lines w ill undoubtedly lay th e ground for furth er research on th is front. (3) T h rough out th e analysis, w e as- sumed th at th e low er bound of zero on th e nominal interest rate w as not a con- straint on th e performance of monetary policy. In Japan, for example, th e sh ort- term nominal rate h as fallen to th e point w h ere th is constraint clearly is a consideration for policy management. S imilarly, in th e U.S . and Europe, th e inflation rates h ave fallen to th e point w h ere th e zero bound limit could con- ceivably affect th e ability to ease rates in th e event of a dow nturn. Under- standing h ow monetary policy sh ould proceed in th is kind of environment is an important task. Wh en th e nominal rate is at zero, th e only w ay a central bank can reduce th e real interest rate is to generate a rise in expected inflation (see th e discussion in A lexander Wol- man 1998, and th e references th erein). How th e central bank sh ould go about th is and w h eth er cooperation from fis- cal policy is necessary are important open questions. A s Wolman (1998) sug- gests, th e conclusions are quite sensi- tive to th e nature of th e inflationary process. (4) A more specific issue, but none- th eless an important one, is to under- stand w h y central banks smooth interest rate adjustments. A s w e discussed in section 5, optimal policies implied by most existing macroeconomic frame- w orks generate path s for th e interest rate th at are much more volatile th an w h at is observed in reality. T h e possi- bility th us arises th at existing models may fail to adequately ch aracterize th e constraints th at policy-makers face in practice. We suggested in section 5 th at some form of model uncertainty migh t be able to account for th is ph enome- non. A noth er alternative is th at central banks may be exploiting th e depen- dency of demand on expected future in- terest rates, as argued by Rotemberg and Woodford (1999). Wh eth er th ese explanations or any oth ers, such as fear of disruption of financial markets, can account for interest rate smooth ing needs to be determined. (5) A somew h at related issue involves h ow a central bank sh ould deal w ith This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions Clarida, Galtl, Gertler: T h e S cience of Monetary P olicy 1703 financial stability. T h e policy rules discussed in th e literature do include contingencies for financial crises. A fre- quently cited reason for w h y monetary policy sh ould not adh ere tigh tly to a simple rule is th e need for flexibility in th e event of a financial collapse. In th e w ake of th e October 1987 stock market crash , for example, most economists supported th e decision of th e Federal Reserve Board to reduce interest rates. T h is support w as based largely on in- stinct, h ow ever, since th ere is virtually no formal th eoretical w ork th at rational- izes th is kind of intervention. More generally, concern about financial sta- bility appears to be an important con- straint on policy-making. A s w e sug- gested in section 5, it is one possible reason w h y central banks smooth inter- est rate ch anges. Understanding th e na- ture of th is concern is clearly a fertile area for research . (6) Finally, w ith few exceptions, vir- tually all th e literature ignores th e issue of transition to a new policy regime.89 In particular, th e rational expectations assumption is typically employed. P olicy simulations th us implicitly presume th at th e private sector catch es on immedi- ately to any regime ch ange. In reality, h ow ever, th ere may be a period of tran- sition w h ere th e private sector learns about th e regime ch ange. T h is kind of scenario may be h igh ly relevant to a central bank th at h as accommodated in- flation for a sustained period of time but is intent on embarking on a disinfla- tion. Modeling private sector learning is a ch allenging but noneth eless impor- tant task. S argent (1999) provides a promising start in th is direction. More w ork along th ese lines w ould be h igh ly desirable. A ppendix: T h e General S olution under Commitment A t time t, th e central bank commits to a state contingent sequence for xt + i and ct + i to maximize max - 2 Et{ I3i[oX x2 + t2+i] =o J subject to th e sh ort-run aggregate supply curve t+t = X Xt + i+ P Et{(tt + 1 + i + t +i w ith Ut + i = pUt + i - I + t +i Follow ing Currie and Levine (1993) and Wood- ford (1998), form th e Lagrangian: max--Et Y, if[eXX2+ i+ T 2 i] = [ + P t+i[ t+ - t+i - ItT + l+ -Ut+i w h ere I Ot + is th e multiplier associated w ith th e constraint at t + i. T h e first order necessary conditions yield: oext+i- 2-t+i=O, ViO0 ct +i + 2 t+i - 2 t+i- I= 0, Vi 2 1 1 2 7tt + - Ot= 0 2 Combining th e first order necessary conditions to eliminate Ot + i th en yields th e optimality condi- tions Xt+i-Xt+i-1= 7-a t+i, Vi21 Xt =--ct OCc S ubstituting th e optimality conditions in th e ag- gregate supply curve to eliminate t + E th en yields a stoch astic difference equation for xt: xt = a Xt - 1 + a13 Et{xt + 1} - -tt w h ere a cc T h e stationary solution to cC(l + P ) + k2 th is difference equation is given by: xt = 6 xt- M 1,;p l (8.1) 1- -1-4f3a2 w h ere 6 e (0,1), implying th e pro- cess for xt is stable. S ubstituting th e solution for xt 89 A n exception is Brayton, Levin, T yron, and Williams (1997) w h o present simulations of policy regime ch anges under different assumptions about th e beh avior of private sector expectations. This content downloaded from 146.155.94.33 on Thu, 5 Jun 2014 02:59:53 AM All use subject to JSTOR Terms and Conditions 1704 Journal of Economic Literature, Vol. XXXVII (December 1999) in th e aggregate supply curve th en yields a solu- tion for T ct. T Et Et= - I + (1_ap)(Ut-Ut-i) S ince rct = P t - P t - 1, th e solution implies a station- ary process for th e price level: P t =6P t- I+ U (l - 6pp) ut T h e stationary beh avior of th e price level results from th e fact th at th e optimality condition effec- tively h as th e central bank adjust demand in re- sponse to movements in th e price level relative to trend. Given t = pt - pt -, th e optimality condi- tion may be expressed as Xt+i= --P t+i Vi 1 T h us, for example, th e central bank contracts demand w h en th e price level rises above trend: h ence, th e trend-reverting beh avior of th e price level. REFEREN CES A iyagari, Rao S . and R. A nton Braun. 1998. "S ome Models to Guide th e Fed," Carnegie-Roch ester Conf. S er. 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