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American Economic Association

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
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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
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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).
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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).
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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.
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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.
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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.
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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.
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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).
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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
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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.
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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).
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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).
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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.
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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.
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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.
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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).
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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.
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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.
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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
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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.
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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.
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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.
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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.
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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.
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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.
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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
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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.
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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).
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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).
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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.
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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).
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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
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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).
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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.
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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
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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.
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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.
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