LAMP Theory

LInIted Asset Aarkets IartIcIatIon, Aonetary IoIIcy and
{Inverted) KeynesIan LogIc.

Fioni: O. Liiiiii
A&|J ||j, 1n.:.j J OrJ:J;
11, 1nJn 5h| J 1nn. nnJ 111, 1|:n.
Jh. 1:.n: `n:h .uu
Ai1n.c1. 1his papoi incoipoialos limiloo assol maikols pailicipalion in oy-
namic gonoial oquiliLiium ano oovolops a simplo analylical fiamowoik foi mon-
olaiy policy analysis. Aggiogalo oynamics ano slaLilily piopoilios of an olhoi-
wiso slanoaio Lusinoss cyclo moool oopono nonlinoaily on lho oogioo of assol
maikol pailicipalion. Whilo `moooialo` pailicipalion ialos slionglhon lho iolo
of monolaiy policy, low onough pailicipalion causos an invoision of iosulls
oiclaloo Ly (`Koynosian`) convonlional wisoom. 1ho slopo of lho ÌS` cuivo
changos sign, lho `1ayloi piinciplo` is invoiloo, oplimal wolfaio-maximizing
monolaiy policy ioquiios a passivo policy iulo ano lho olocls ano piopagalion
of shocks aio changoo. 1ho conoilions foi lhoso iosulls lo holo aio iolalivoly
milo compaioo lo somo oxisling ompiiical ovioonco. Oui iosulls may juslify
Foo`s Lohavioi ouiing lho `Gioal Inlalion` poiioo.
Keyvords: |.n.J n nn:| n:..n.n; Jjnnn. jn:n| j&.-
|.h:.&n; njj:jn JnnnJ; Jnj|: 1:.n.|; .nn| nnn:j |.j; :n|
;.n)J:n.nnj.
JEL codes: 1.; G11; 1; 11; 1.; 1.
Aooioss: Numolo Collogo, Univoisily of Oxfoio, Now Ioao, OX1 1NF, Oxfoio, UK; omail:
loiin.LilLiio^numolo.ox.ac.uk.
I am pailiculaily inooLloo lo IoLoilo Ioiolli ano Giancailo Coisolli foi numoious oiscussions
ano aovico. I am gialoful lo Joioi Gal, Anoiow Scoll, Miko Wooofoio ano Iogoi Faimoi foi
holpful, oolailoo commonls. I also Lonolloo fiom commonls al vaiious slagos fiom: Kosuko Aoki,
Miko Ailis, Gianluca Lonigno, Iaul Loigin, Giusoppo Loilola, FaLiico Collaio, Miko Haliassos,
Slophanio Schmill-Gioho, FaLio Ghiioni, NoLu Kiyolaki, Davio Lopoz-Salioo, AlLoil Maicol,
Alox Michaolioos, 1ommaso Monacolli, John MuollLauoi, Goinol Muolloi, Kiis Nimaik, FaLiizio
Ioiii, Jon Skinnoi, Jaumo Vonluia, ano an anonymous iofoioo of lho LCL WI soiios (whoio
an oailioi voision appoais as WI4082004). Iailicipanls al lho CLII`s 2004 Luiopoan Summoi
Symposium in Maciooconomics in 1aiiagona, ano sominais al Lonoon School of Lconomics, CILI-
Univoisilal Iompou FaLia, Numolo Collogo, Oxfoio, Luiopoan Univoisily Inslilulo, LiikLock ano
IGILI-Locconi pioviooo valuaLlo commonls. Spocial lhanks lo Iolano SliauL, my coaulhoi in
iolaloo woik. All oiiois aio mino.
1
2 FLOIIN O. LILLIIL
1. IntroductIon
A liomonoous amounl of iosoaich has giown ioconlly sluoying monolaiy policy
in oplimizing, oynamic gonoial oquiliLiium moools. 1ho impoilanco of lhis iosoaich
ano ils inluonco on ioal-lifo policymaking nooo nol Lo sliossoo hoio fuilhoi. An
oxcollonl ovoiviow of lho slalo-of-lho-ail in lho lolo is lho ioconl Look Ly Michaol
Wooofoio (2008)
1
.
Al lho hoail of lhis liloialuio lios somo foim of an àggiogalo Luloi oqualion`,
oi ÌS` cuivo, ooiivoo fiom lho housoholos` inoivioual Luloi oqualions. 1his iola-
lionship piooicls lhal housoholos will suLslilulo consumplion inloilompoially - foi
oxamplo using assols. 1hoio is lhus an invoiso iolalionship Lolwoon aggiogalo con-
sumplion looay ano lho oxpocloo ioal inloiosl ialo. Using lhis as a Luiloing Llock,
lho liloialuio ooiivos noimalivo piosciiplions, somo of which aio ioLusl acioss a
wioo vaiioly of mooolling slialogios. Fiisl, lho conlial Lank nooos lo aoopl an `n-
.` policy iulo whoioLy il incioasos lho nominal inloiosl ialo Ly moio lhan inla-
lion (i.o. incioasos lho :n| inloiosl ialo), foi policy lo Lo consislonl wilh a uniquo
ialional oxpoclalions oquiliLiium; lhis is laLoloo `lho 1ayloi Iiinciplo` following
Wooofoio (2001)
2
. Soconoly, wolfaio-Lasoo oplimal policy ioquiios minimizalion
of inlalion ano oulpul vaiiaLilily, ano also implios lhal lho nominal inloiosl ialo
incioaso Ly moio lhan inlalion. 1hiioly, whon lhoio is no liaoo-ol Lolwoon oulpul
ano inlalion slaLilizalion, full slaLilizalion of Lolh is possiLlo Ly making lho policy
insliumonl oqual lho `nn&:n| :n J .n:`; howovoi, a commilmonl lo fullll lho
1ayloi piinciplo is slill ioquiioo lo onsuio lhal lho iosulling oquiliLiium is uniquo.
Iolalooly, an inloiosl ialo pog
8
(ano any `n.` policy iulo) woulo loao lo mul-
liplo oquiliLiia ano slalionaiy sunspol luclualions (i.o. oiivon Ly Loliofs ano nol
funoamonlals). Laslly, unanlicipaloo ioal inloiosl ialo incioasos aio conliaclionaiy.
1his papoi shows lhal limiloo assol maikol pailicipalion has a non-linoai olocl
on lhoso piooiclions. If pailicipalion is iosliicloo Lolow a coilain lhiosholo, lho
piooiclions aio strengtLened: as moio (Lul nol `loo many`) pooplo oo nol holo
assols, lho link Lolwoon inloiosl ialos ano aggiogalo oomano Locomos sliongoi,
ano monolaiy policy is moio oloclivo. Howovoi, whon pailicipalion is iosliicloo
Loyono a givon lhiosholo (i.o. onough agonls oo nol pailicipalo in assol maikols),
lho slanoaio lhooiolical piosciiplions oi piooiclions aio reversed. Namoly, (i) lho
ÌS cuivo` has a posilivo slopo, (ii) lho 1ayloi Iiinciplo is invoiloo, (iii) oplimal
policy ioquiios a passivo iulo, ano (iv) olocls of somo shocks aio ovoiluinoo. In lho
limil (whon noLooy holos assols), aggiogalo oomano coasos lo Lo linkoo lo inloiosl
ialos ano monolaiy policy Locomos inoloclivo .
Wo ooiivo oui iosulls analylically in a slanoaio oynamic gonoial oquiliLiium
moool incoipoialing |.n.J n nn:| n:..n.n (hoioinafloi 1`1). Wo
lisl piovioo somo simplo inluilion foi oui iosulls, iolaling oui fiamowoik lo a
simplo Koynosian cioss. Wo lhon oullino lho gonoial oquiliLiium moool ano ooiivo
1
Lailioi ovoiviows of lhoso issuos compiiso, amongsl olhois, Claiioa, Gali ano Goilloi (1000)
ano Gooofiiono ano King (1007).
2
1his conclusion changos unooi somo mooolling choicos. Foi oxamplo, in conlinuous limo,
Dupoi (2000) shows lhal moioly inliooucing capilal invalioalos lho 1ayloi piinciplo. A non-
Iicaioian lscal policy in lho sonso of Wooofoio (1006) can also ioquiio a passivo policy iulo foi
oquiliLiium ooloiminacy, as noloo also Ly Loopoi (1001). In an ovoilapping gonoialions fiamowoik,
Lonassy (2001) also shows lhal lho 1ayloi piinciplo is invalioaloo.
8
As in lho much coloLialoo papoi Ly Saigonl ano Wallaco (107).
LIMI1LD ASSL1 MAIKL1S IAI1ICIIA1ION AND MONL1AIY IOLICY. 8
ils canonical foim, iooucing il lo lwo familiai oqualions: a Ìhilips cuivo` ano an
ÌS cuivo`. 1his makos oui moool oasily compaiaLlo lo lho woikhoiso slicky piico
moool, which occuis as a spocial caso
4
; sinco lho iosulling syslom is voiy simplo,
il mighl Lo of inooponoonl inloiosl lo somo iosoaichois. NolaLly, wo manago lo
capluio lho inluonco of LAMI on aggiogalo oynamics lhiough a uniquo paiamoloi,
lho olaslicily of aggiogalo oomano lo ioal inloiosl ialos. 1his paiamoloi ooponos
non-linoaily on lho oogioo of assol maikol pailicipalion ano is al lho coio of lho
inluilion foi all oui iosulls. 1ho oogioo of LAMI nocossaiy ano sumcionl foi oui
iosulls lo holo is small whon compaioo lo ompiiical oslimalos of CampLoll ano
Mankiw (1080) oi lo oala on assol maikol pailicipalion o.g. in Mulligan ano Sala-
i-Mailin (2000) oi Vissing-Joigonson (2002).
Following an omoiging liloialuio ioviowoo Lolow, wo assumo lhal somo agonls
havo zoio assol holoings, Loing oilhoi unaLlo (consliainoo) oi unwilling (myopic,
uninfoimoo) lo pailicipalo il assol maikols
. Lmpiiical suppoil foi oui mooolling

choico comos fiom a vaiioly of oiioclions, o.g. failuio of consumplion smoolhing
as a gooo oosciiplion of aggiogalo Lohavioi, high shaio of woallh-pooi ano assol-
pooi housoholos in lho oala, low shaio of housoholos holoing vaiious assols. In a
coloLialoo papoi, CampLoll ano Mankiw (1080) oslimaloo lhal aLoul 40 lo 0 poi-
conl of lho US populalion moioly consumo lhoii cuiionl incomo
6
. Dala on woallh
oisliiLulion (soo i.a. Woll (2000) ano Woll ano Canoi (2002)) shows lhal a high
fiaclion of lho US populalion is woallh-pooi oi assol-pooi; lho oxacl fiaclion oo-
ponos on lho pailiculai woallh vaiiaLlo usoo, Lul il is sliiking lhal 0 poiconl of
lho US populalion havo loss lhal 000 USD in liquio assols. Il is haio lo aiguo lhal
lhoso housoholos havo lho moans lo poifoclly smoolh consumplion. Whon classify-
ing housoholos as àssol-pooi` Lasoo on 1000 ISID oala, Woll ano Canoi lno lhal
41.7 poiconl can Lo classiloo as such whon homo oquily is oxcluooo fiom nol woilh,
whoioas 2.0 poiconl aio assol-pooi Lasoo on nol woilh oala. Moioovoi, oala on as-
sol holoings piosonloo i.a. in Mankiw ano Zoloos (1001), Vissing-Joigonson (2002),
Guiso, Haliassos ano Japolli (2002) shows lhal fow pooplo holo assols in vaiious
foims. Foi inslanco, Vissing-Joigonson (2002) iopoils Lasoo on lho ISID oala lhal
of US populalion 21.7 poiconl holo slock ano 81.40 poiconl holo Lonos
7
. Dala
fiom lho 1080 Suivoy of Consumoi Financos (soo o.g. Mulligan ano Sala-i-Mailin
(2000)) shows lhal 0 poiconl of US populalion hao no inloiosl-Loaiing lnancial
assols, whilo 2 poiconl hao no chocking accounl oilhoi.
Moools liying lo incoipoialo lhis insighl (lhal nol all agonls Lohavo as pio-
sciiLoo Ly slanoaio nooclassical lhooiy) havo Loon usoo in al loasl lwo slianos of
lho maciooconomic liloialuio. Fiisl, somo voision of lhis assumplion has Loon pio-
posoo Ly Mankiw (2000) ano oxlonooo Ly Gal, Lopoz-Salioo ano Vallos (2008) foi
4
1hoio is voiy high vaiianco iogaioing a laLol foi such a fiamowoik in lho liloialuio. 1his
goos fiom `Now Koynosian` (Claiioa Gali ano Goilloi 1000 - honcofoilh CGG) lo `Now Nooclassical
synlhosis` (Gooofiiono ano King 1007) lo `Noomonolaiisl` (KimLall 1006). Wooofoio (2008) iofois
lo such a fiamowoik as `Noo-Wicksollian`.
In an apponoix, wo oullino a simplo moool in which high onough piopoilional liansaclion

cosls can ialionalizo limiloo pailicipalion. Wo also ioviow somo ovioonco concoining lho magni-
luoo of lhoso cosls nocossaiy lo gonoialo oLsoivoo non-pailicipalion lovols.
6
Olhoi papois (Flavin (19S1), Zoloos (19S9)) lno similai iosulls, ano sluoy wholhoi lho
failuio lo smoolh consumplion comos fiom liquioily consliainls.
7
Sho fuilhoi usos lhis holoiogonoily lo oLlain Lolloi micio oslimalos of lho olaslicily of
inloilompoial suLslilulion ano olhoi piofoionco paiamolois
4 FLOIIN O. LILLIIL
lscal policy issuos. Socono, il is lho noim in lho monolaiy policy liloialuio liying
lo capluio lho `liquioily olocl` (o.g. Alvaioz, Lucas ano WoLoi (2001), Occhino
(2008)). Oui assumplion is voiy closo in spiiil lo lhis socono appioach
8
: a suLsol
of housoholos cannol liaoo assols (lhis is somolimos calloo `maikol sogmonlalion`).
Inliooucing physical capilal as in Mankiw ano GLV woulo moioly allow foi moio
holoiogonoily: lhis is an impoilanl oxlonsion, Lul is nol nooooo foi any of oui
poinls.
Whilo having Loon alioaoy usoo lo oxplain somo puzzlos in lho lnanco-assol
piicing ano in lho lscal policy liloialuio
0
, lhis mooolling choico has only ioconlly
Loon incoipoialoo inlo lho slicky-piico monolaiy policy iosoaich. A ioconl papoi
Ly Gal, Lopoz-Salioo ano Vallos (2008L, honcofoilh GLV) inoooo aiguos lhal lho
1ayloi piinciplo is nol a gooo guioo foi policy if somo ìulo-of-lhumL` agonls oo
nol holo physical capilal. Namoly, GLV aiguo lhal if lho conlial Lank iosponos lo
cuiionl inlalion via a simplo 1ayloi iulo, whon lho shaio of ìulo-of-lhumL` agonls
is high onough lho iosponso coomcionl has lo Lo highoi lhan lhal suggosloo Ly lho
1ayloi piinciplo. On lho conliaiy, foi a iulo iosponoing oilhoi lo pasl oi fuluio
oxpocloo inlalion, GLV suggosl, Lasoo on numoiical simulalions, lhal foi a high
shaio of non-assol holoois lho policy iulo nooos lo violalo lho 1ayloi piinciplo lo
onsuio oquiliLiium uniquonoss. Ono of oui papoi`s conclusions is clososl (allhough
nol ioonlical) lo lhis lasl poinl. Insloao, wo show analilically lhal an Ìnvoiloo 1ay-
loi piinciplo` holos .n jn:n| whon assol maikol pailicipalion is iosliicloo onough,
no malloi wholhoi lho policy iulo iosponos lo conlompoianoous oi fuluio oxpocloo
inlalion. Wo piovioo inluilion ano oxplain lho oconomic mochanism unooilying
oui iosull as pail of a moio gonoial lhomo having lo oo wilh lho aggiogalo oo-
mano`s sonsilivily lo inloiosl ialos, as anlicipaloo aLovo. Wo also show how lho
1ayloi piinciplo can Lo iosloioo Ly oilhoi an appiopiialo iosponso lo oulpul oi via
oisloilionaiy iooisliiLulivo laxalion of oivioono incomo.
Oui iosulls can Lo poihaps mosl iolovanl foi analyzing (i) oovoloping oconomios,
in which pailicipalion in assol maikols is noloiiously limiloo; (ii) hisloiical opisooos
ouiing which ovon oovolopoo oconomios oxpoiioncoo oxcoplionally low assol maikol
pailicipalion. Iogaioing lho lalloi, many aulhois havo aiguoo lhal policy Lofoio
Volckoi was `Laoly` conoucloo along ono oi sovoial oimonsions, which loo lo woiso
maciooconomic poifoimanco as compaioo lo lho Volckoi-Gioonspan oia. Ono such
aigumonl iolios upon lho oslimaloo pio-Volckoi policy iulo non fulllling lho `1ay-
loi piinciplo`, honco conlaining lho sooos of maciooconomic inslaLilily oiivon Ly
non-funoamonlal uncoilainly (CGG (2000), LuLik ano Schoifhoioo (2004)). In a
companion papoi (LilLiio (2004)), wo lako a .. slanopoinl ano aiguo lhal Foo
policy was Lolloi managoo lhan convonlional wisoom oiclalos, if lnancial maikol
impoifoclions woio poivasivo ouiing lho `Gioal Inlalion` poiioo. 1ho liomonoous
lnancial innovalion ano ooiogulalion piocoss in lho 1070-1082 poiioo (samo limo
as coming lo omco of Iaul Volckoi) ano lho aLnoimally high oogioo of iogulalion
8
Iapois in lho `liquioily olocl` voin sluoy a complololy oiloionl quoslion: wholhoi a con-
liaclionaiy monolaiy policy shock (oocioaso of monoy supply) is inoooo associaloo lo an incioaso
in inloiosl ialos, ano has olocls consislonl wilh lho oala.
0
Gali, Lopoz-Salioo ano Vallos (2002) aiguo lhal lhis mooolling assumplion can holp oxplain-
ing lho olocls of govoinmonl sponoing shocks if lhis is oolcil-lnancoo, laxalion is lump-sum ano
laLoi is oomano-ooloiminoo. Soo also LilLiio ano SliauL (2008L) foi oiloionl laLoi maikol ano
Luogolaiy sliucluios.
LIMI1LD ASSL1 MAIKL1S IAI1ICIIA1ION AND MONL1AIY IOLICY.
in lho 1070`s piovioo somo suppoil lo lhis viow. Lslimalion of an IS cuivo sug-
gosls lhal ils slopo changoo sign aiouno lho samo limo, consislonl wilh oui lhooiy.
Honco, a passivo policy iulo implioo a ooloiminalo oquiliLiium, was closo lo op-
limal policy ano allows foi lho olocls of funoamonlal shocks lo Lo sluoioo. Wo
show lhal lho piooiclions of oui moool aio in lino wilh slylizoo facls ano ompiiical
lnoings. 1ho chango in lnancial impoifoclions mighl holp oxplain Lolh lho chango
in maciooconomic poifoimanco ano lho chango in lho policy iosponso; lho aLiupl
chango in lho policy iulo mighl nol Lo a moio coincioonco, Lul an oplimal iosponso
lo lho sliucluial chango.
1ho iosl of lho papoi is oiganizoo as follows. In Soclions 2 wo piosonl a sliippoo-
oown voision of oui moool, usoful foi ìnspocling lho mochanism` inluilivoly, whilo in
Soclions 8 ano 4 wo inlioouco lho LAMI gonoial oquiliLiium moool ano ils iooucoo
log-linoai foim, ano oiscuss oui coio iosulls inluilivoly. A oiscussion of lho laLoi
maikol oquiliLiium usoful foi fuilhoi inluilion is also piosonloo. Soclion oullinos
lho Ìnvoiloo 1ayloi Iiinciplo` ano oiscussos ways lo iosloio lho 1ayloi piinciplo
Ly slaLilizing lho oulpul gap. Soclion 6 analyzos oplimal monolaiy policy, Soclion
7 calculalos analylically lho iosponsos of lho oconomy lo cosl-push, lochnology ano
sunspol shocks unooi vaiious sconaiios ano Soclion 8 concluoos. Mosl lochnical
oolails aio conlainoo in lho Apponoicos.
2. LInIted Asset Aarket IartIcIatIon and tLe {on-)KeynesIan Cross
Wo will slail wilh an oullino of lho main gonoial implicalions of limiloo assol
maikol pailicipalion in a simplo fiamowoik. 1ho analysis is highly simpliloo Ly
aoopling a sol of assumplions lhal, whilo making oxposilion simplo, aio nol noc-
ossaiy foi lho main iosulls lo holo. 1his is oono lo isolalo lho coio mochanism
ano facililalo compaiison wilh a loxlLook `Koynosian cioss` fiamowoik
10
. All lho
simplifying assumplions aio iolaxoo in lho fully miciofounooo moool in lho noxl
soclion.
Supposo aggiogalo oxponoiluio consisls of consumplion only. 1hoio aio lwo
lypos of agonls: assol holoois inooxoo Ly o, liaoing slalo-conlingonl assols ano
shaios in lims ano non-assol holoois inooxoo Ly H, who oo nol pailicipalo in any
of lho assol maikols ano simply consumo lhoii cuiionl incomo. 1ho shaios of lhoso
agonls aio 1` ano ` iospoclivoly ano aio assumoo lo Lo conslanl. 1olal consump-
lion in log-linoai oovialions fiom sloaoy slalo is givon Ly c = `c
1
[1 `[ c
S
, whoio
c
is consumplion of gioup ,.
11
Supposo fuilhoimoio foi simplicily lhal laLoi sup-
ply of non-assol holoois is inolaslic :
1
= 0, such lhal lhoii consumplion is oqual lo
lho ioal wago c
1
= n ano lolal laLoi supply is givon Ly : = [1 `[ :
S
. Assumo lhal
assol holoois` laLoi supply oLoys a slanoaio oplimalily conoilion ,:
S
= n c
S
,
whoio , is lho invoiso Fiisch olaslicily of laLoi supply foi lypo o. 1olal consumplion
will honco Lo: c = `n [1 `[ c
S
= `,
S
:
S
c
S
=
X
lX
,: c
S
.Finally, assumo
lhal lho pioouclion funclion foi lnal oulpul in log-linoai foim is j = [1 j[ :,
whoio j iopiosonls Lolh lho sloaoy-slalo nol maik-up ano lho oogioo of aggiogalo
incioasing ioluins lo scalo
12
. Using lhis wo oLlain lho oquivalonl of lho `plannoo
10
I lhank Joioi Gal foi having suggosloo lho `Koynosian cioss` analogy.
11
1his appioximalion only holos if sloaoy-slalo consumplion shaios of lho lwo lypos aio
oqual, i.o. assol incomo is zoio in sloaoy-slalo.
12
1his insuios lhal assol incomo is zoio in sloaoy-slalo, so lhal all algoLia hoio is consislonl.
6 FLOIIN O. LILLIIL
oxponoiluio` (oi àggiogalo oomano`) oqualion fiom slanoaio Koynosian moools
(soo foi oxamplo Davio Iomoi`s loxlLook):
(2.1) c = c
_
j
, r
t
_
=
`
1 `
,
1 j
j c
S
1his oqualion links aggiogalo oxponoiluio lo cuiionl incomo, consumplion of
assol holoois ano oxogonous lochnology. Nolo lhal (2.1) is nol a iooucoo-foim io-
lalionship sinco c, j, c
S
aio all onoogonous vaiiaLlos, which will Lo ooloiminoo in
gonoial oquiliLiium. Howovoi, wo can lhink of (2.1) as a schooulo in lho (j, c) spaco,
foi a j.n lovol of c
S,|
. In lhal sonso, wo can say lhal aggiogalo oomano (oxponoi-
luio) ooponos posilivoly on cuiionl incomo ano nogalivoly on lho ioal inloiosl ialo.
Wo can oolno lho (pailial) `maiginal pioponsily lo consumo` oul of cuiionl incomo
as 0c,0j =
X
lX
,
l
0. 1his `maiginal pioponsily lo consumo` is in facl a n:.n|
maiginal pioponsily, i.o. kooping lxoo consumplion of assol holoois c
S
. In oquiliL-
iium, of couiso, all oulpul is consumoo. Wo will loosoly iofoi lo 0c,0j as `maiginal
pioponsily lo consumo` in lho iomainooi. 1ho nogalivo impacl of ox-anlo ioal in-
loiosl ialos r
t
on aggiogalo oomano comos fiom a slanoaio Luloi oqualion foi
consumplion of assol-holoois: c
S
= c
t
S
[r
t
[ , whoio r is lho nominal inloiosl
ialo ano lho inloilompoial olaslicily of suLslilulion in consumplion is noimalizoo
lo ono wilhoul loss of gonoialily.
1ho maiginal pioponsily lo consumo is incioasing in (i) lho shaio of non-assol
holoois `, foi lhis moans lhal a highoi fiaclion of lolal populalion simply consumos
lho ioal wago ano is insonsilivo lo inloiosl ialo movomonls ano (ii) lho oxlonl lo
which laLoi supply is inolaslic ,, foi lhis implios lhal small vaiialions in houis (ano
oulpul) aio associaloo lo laigo vaiialions in ioal wago ano honco in lho consumplion
of non-assol holoois. Honco, (2.1) is consislonl wilh Koynos` viows lhal lho aggio-
galo pioponsily lo consumo ooponos on `h :.n.| n &h.h .nn . J..JJ
h&n h .nJ..J&n| n.nj ]h nn&n.j] - &h.h nnj &]: nJ.]n.n
n && . .n:nJ` ano fuilhoi lhal `& nnj hn nn| nn n||&nn J:
h .h| :n.n J njj:jn n&n.n h hnnj .n h J.:.h&.n J
n j.n :n| .nn h&n n::n&: nnJ :n.: :&|.nj J:n n hnnj .n
h &nj-&n.` (Koynos [108[ , Chaploi 8, Look III).
1ogolhoi wilh lho conoilion lhal consumplion oqual oulpul c = j, oqualion
(2.1) loaos lo lho Koynosian cioss ano lho slanoaio IS oqualion in caso 0c,0j < 1. A
posilivo Lul low onough ` makos lho oconomy `moio Koynosian` sinco lho pioponsily
lo consumo oul of cuiionl incomo Locomos laigoi lhan zoio, ils valuo unooi full
pailicipalion. Howovoi, nolo lhal lho maiginal pioponsily lo consumo oul of cuiionl
incomo (oulpul) 0c,0j can Locomo j:n: hnn n foi high valuos of ` anooi
,, namoly whon ` [1 ,, (1 j)[
l
. 1his is lho caso whon lhoio aio onough
agonls who consumo lhoii wago incomo n, ano lho lalloi is sonsilivo onough lo
lolal incomo j (laLoi supply is inolaslic onough).
Wo laLol lhis caso `non-KeynesIan` sinco Koynos Loliovoo a maiginal piopon-
sily lo consumo loss lhan unily lo Lo `n J&nJnnnn| jh|j.n| |n&`. Howovoi,
il shoulo Lo noloo lhal lho aggiogalo implicalions of (4.1) oo nol nocossaiily con-
liaoicl Koynos` viows, as aiguoo Lolow (lho oiloionco coming fiom oui oolnilion
of a maiginal pioponsily foi a j.n c
S
). Wo plol (2.1) in lhis caso along wilh lho
c = j schooulo in lho `Non-Koynosian cioss` in Figuio1, whoio an incioaso in lho
ioal inloiosl ialo movos lho (2.1) schooulo iighlwaio (Ly inloilompoial suLslilulion)
loaoing lo highoi consumplion ano oulpul.
c
y
c=y
c=c(y,r-p
e
)
Fig.1: 1ho Non-Koynosian Ciosss
An immooialo implicalion of lho aLovo is lhal lho IS cuivo swivols (ils slopo
hnnj .jn). Consumplion of assol holoois is iolaloo lo lolal oulpul comLining
(2.1) wilh c = j Ly c
S
= cj, whoio c = 1
X
lX
,
l
= 1 0c,0j. Nolo lhal c
Locomos nogalivo whon 0c,0j 1. Consumplion of assol holoois can Lo noga-
livoly iolaloo lo lolal oulpul sinco an incioaso in oomano can only Lo salisloo Ly
movomonls of (as opposoo lo movomonls along) lho laLoi supply schooulo whon
onough pooplo holo no assols ano laLoi supply is inolaslic onough. Lul lho nocos-
saiy iighlwaio shifl of laLoi supply can only como fiom a njn. .nn ]
on consumplion of assol holoois. 1his nogalivo incomo olocl is onsuioo in gonoial
oquiliLiium Ly a n.n| fall in oivioono incomo
18
. 1ho n.n| oocioaso in piof-
ils is a naluial iosull of inolaslic laLoi supply, sinco lho incioaso in maiginal cosl
(ioal wago) woulo moio lhan oulwoigh lho incioaso in salos (houis). 1hoiofoio, lhis
mochanism is consislonl wilh Koynos` [op.cil.[ slalomonl lhal `h n&n.n J
h &n|h-&n.nj |n nnj h r:n|j &.h| &nJ:n hnnj .n h
nnj-n|& J . &n|h`.
SuLsliluling c
S
= cj inlo lho Luloi oqualion wo oLlain lho aggiogalo ÌS cuivo`,
which has a posilivo slopo whon c < 0:
j = j
t
c
l
[r
t
[ .
Whilo wo laLol lho caso whoio c < 0 `non-Koynosian` (foi il coiiosponos lo a
`maiginal pioponsily lo consumo` laigoi lhan ono, which Koynos viowoo as implau-
siLlo) il shoulo Lo omphasizoo lhal Koynos in facl Loliovoo lhal lho impacl of ioal
inloiosl ialos on aggiogalo sponoing is nol nocossaiily nogalivo, sinco il ooponos on
many conliaoicling faclois (soo noxl foolnolo). Among lhoso, ho in facl hinls lo
18
1his is soon cloaily in lho miciofounooo moool of lho noxl Soclion. Wo will also show lhal a
polonlial fall in oivioono incomo ooos nol nocossaiily imply lhal n&n| piolls fall in oquiliLiium.
Inluilivoly, lho nogalivo incomo olocl of a polonlial fall in oivioonos onsuios a shifl in laLoi supply
ano an incioaso in houis ano a smalloi oquiliLiium incioaso in wago, piovonling piolls fiom falling.
8 FLOIIN O. LILLIIL
`h n:.n.n : J:.n.n .n h :. J &:..`, which is al lho hoail of
oui mochanism
14
.
Nol suipiisingly, lho implicalions of lhis insighl on monolaiy policy ano macio-
oconomic slaLilily aio oiamalic. Ioconl iosoaich in monolaiy policy aiguos lhal
monolaiy policy nooos lo Lo àclivo` in oiooi lo onsuio maciooconomic slaLil-
ily. Foimally, if nominal inloiosl ialos aio sol as a funclion of oxpocloo inlalion
r = c
t
t
, lho iosponso coomcionl nooos lo fullll whal Wooofoio (2001) has la-
Loloo `lho 1ayloi piinciplo`: c
t
1. 1his onsuios oquiliLiium ooloiminacy (whon
piicos aio sol on a foiwaio-looking Lasis) oi slaLilily - whon lho Ihilips cuivo is
Lackwaio-looking (soo 1ayloi (1000)).
Cloaily, in lho non-Koynosian caso an Ìnvoiloo 1ayloi piinciplo` holos: in
oiooi lo onsuio slaLilily, monolaiy policy nooos lo Lo passivo: c
t
< 1. Olhoiwiso,
if oxpocloo inlalion incioasos, an aclivo policy woulo loao lo an incioaso in ioal
inloiosl ialos ano a Loosl lo consumplion ano oulpul (Ly lho non-Koynosian logic
aLovo). If a Ihilips cuivo holos such lhal inlalion ano oulpul aio posilivoly iolaloo,
inlalion also incioasos valioaling lho inilial incioaso. Ono way lo iosloio lho 1ayloi
Iiinciplo woulo Lo foi lho monolaiy aulhoiily lo incioaso inloiosl ialos whon oulpul
incioasos aoopling a iulo of lho foim r = c
t
t
c
r
j. Sinco consumplion of assol
holoois is c
S
= c
t
S
(c
t
1)
t
c
r
j, lho plannoo oxponoiluio lino Locomos:
c =
_
`
1 `
,
1 j
c
r
_
j c
t
S
[c
t
1[
t
.
Honco, iosponoing lo oulpul iosloios lho 1ayloi Iiinciplo Ly making lho slopo of lho
ILL loss lhan ono whon c
r
c 0. In lhis caso, a non-funoamonlal incioaso in
oxpocloo inlalion woulo nol iosull in an incioaso in oulpul gap, ano honco aclual
inlalion woulo nol incioaso. 1ho iosl of lho papoi piosonls lho miciofounooo
gonoial oquiliLiium moool loaoing lo lho `non-Koynosian` caso ano sluoios closoly
ils implicalions foi aggiogalo oynamics, ooloiminacy piopoilios of inloiosl ialo
iulos, oplimal monolaiy policy ano lho olocls of shocks.
3. A CeneraI EquIIILrIun AodeI vItL LAAI
1ho moool wo uso is a slanoaio cashloss oynamic gonoial oquiliLiium moool,
augmonloo foi limiloo assol maikols pailicipalion. 1ho lalloi foaluio is inliooucoo
Ly assuming lhal somo of lho housoholos aio oxcluooo fiom assol maikols, whilo
14
`Jh .n&n J h. Jn: ]h :n J .n:] n h :n J nJ.nj & J n j.n
.nn . n n jJ Jn| J J&h. 1: h |n.n| h:j J h :n J .n:, &h.h &n
hnJ n h .Jn hn h :n J .n: &n h Jn: &h.h h:&jh h &|j nnJ JnnnJ
J: n.nj .n j&.|.h:.&n, . &n courcu1cuI Io suosc hn rnJ.&: n cousunI1ou
. . n:. ucjuI1rcI scus1I1rc Io cluujcs 1u Ilc ruIc o] 1uIcrcsI, hn nnj :. .n h
:n J .n: &&|J n:.nh|j J.n.n.h n&n.n. 1 hn |nj hn :jn.J, h&:,
hn h IoIuI c_ccI o] cluujcs 1u Ilc ruIc o] 1uIcrcsI n h :nJ.n nJ n :n
n&n.n . conIci uuu uuccrIu1u, h.nj JnJn n cou1cI1uj nJn., .n n
J h &h]. n. &n:J n.nj &.|| h n: n.|j n.]J .J h :n J .n: :.,
&h.| h: &.|| h ucuLcucu. [...[ 1nJ.:|j h: nnj h n: ], h&jh n n|| .n h
nn J.:.n. 1:hn h nosI 1norIuuI 1uucucc, :n.nj h:&jh hnnj .n h :n J
.n:, n h :nJ.n nJ & J n j.n .nn, JnJ n h ] J h hnnj
n h n:.n.n : J:.n.n .n h r1cc o] sccur1I1cs uuu oIlcr usscIs. 1: .J n nnn
. n]j.nj n &.nJJn|| .n:nn .n h n|& J h. n.n|, . . nn&:n| hn h. n. &n:J
&::n nJ.nj h&|J h :njhnJ, n h&jh .n :n J .nn h. n.n| . &:h n
n: hnn hJ:; nnJ ucuLcucu .J h . &]:.nj cu1IuI Iosscs.` [Koynos op.cil., omphasis
aoooo[
olhois liaoo in complolo maikols foi slalo-conlingonl socuiilios (incluoing a mai-
kol foi shaios in lims). 1ho failuio lo liaoo in assol maikols coulo como fiom a
vaiioly of souicos, having lo oo wilh oilhoi piofoioncos oi maikol fiiclions. Wo
omphasizo maikol fiiclions, ano in Apponoix 1 oullino a simplo assol piicing moool
wilh piopoilional liansaclion cosls. Wo show how a oisliiLulion of piopoilional
liansaclion cosls can Lo founo lhal ialionalizos lho oxclusion of a givon shaio of
housoholos fiom assol maikols
1
. In lighl of lhis insighl, in lho iomainooi of lho pa-
poi wo assumo lho fiaclion of non-assol holoois lo Lo oxogonous, as in mosl papois
on maikol sogmonlalion ano limiloo pailicipalion, o.g. Alvaioz, Lucas ano WoLoi
(2001). Whilo oui Lasolino moool`s iooucoo foim is oLsoivalionally oquivalonl lo
Gal, Lopoz-Salioo ano Vallos (2008), lhoio aio a fow impoilanl oiloioncos (asioo
lho oiloionco in focus omphasizoo Lofoio). Fiislly, wo aLsliacl fiom accumulalion
of physical capilal: lhis allows us lo oLlain analylical solulions ano holps unooi-
slanoing lho mochanism Lohino oui iosulls
16
. Soconoly, wo moool oxplicilly lho
assol maikols, ano nolaLly lho maikol foi shaios; inoooo, lho lalloi will Lo al lho
coio of oui iosulls. 1wo olhoi oiloioncos aio: (i) an aooilivoly sopaiaLlo ulilily
funclion, usoful foi omphasizing lho iolo of laLoi supply; ano (ii) a lxoo cosl in
lho inloimooialo-gooos socloi, which whon sol piopoily insuios lhoio aio no long-
iun piolls (ano incioasing ioluins). 1ho oiloioncos in iosulls aio oosciiLoo ano
oxplainoo in oolail Lolow.
A iolo foi monolaiy policy is inliooucoo Ly assuming lhal piicos aio slow lo
aojusl. 1hoio is a conlinuum of housoholos, a singlo poifoclly compolilivo lnal-
gooo piooucoi ano a conlinuum of monopolislically compolilivo inloimooialo-gooos
piooucois solling piicos on a slaggoioo Lasis. 1hoio is also a monolaiy aulhoiily
solling ils policy insliumonl, lho nominal inloiosl ialo.
3.1. HouseLoIds. 1hoio is a conlinuum of housoholos [0, 1[ . A 1 ` shaio
is iopiosonloo Ly housoholos who aio foiwaio looking ano smoolh consumplion,
Loing aLlo lo liaoo in all maikols foi slalo-conlingonl socuiilios: `n h|J:`
oi savois. Lach assol holooi (suLsciipl o oonolos lho iopiosonlalivo assol holooi)
choosos consumplion, assol holoings ano loisuio solving lho slanoaio inloilompoial
pioLlom: max 1
|
I=0
,
I
l
S
(C
S,|I
,
S,|I
), suLjocl lo lho soquonco of consliainls:
1
S,|
\
S,|l
\
|
_ 7
S,|
\
S,|
(\
|
1
|
1
|
) \
|
S,|
1
|
C
S,|
.
Assol holooi`s momonlaiy folicily funclion l
S
(C
S,|
,
S,|
) = lnC
S,|
0
S
l,
:
S,|
, (1 ,
S
)
lakos lho foim consiooioo hoio lo Lo consislonl wilh mosl DSGL sluoios
17
. ,
(0, 1) is lho oiscounl facloi, 0
S
0 inoicalos how loisuio is valuoo iolalivo lo con-
sumplion, ano ,
S
0 is lho coomcionl of iolalivo iisk avoision lo vaiialions in
loisuio. C
S,|
,
S,|
aio consumplion ano houis woikoo Ly savoi (limo onoowmonl is
noimalizoo lo unily), 1
S,|
is lho nominal valuo al ono of poiioo l of a poilfolio of
all slalo-conlingonl assols holo, oxcopl foi shaios in lims. Wo oislinguish shaios
1
Lmpiiical oslimalos of lowoi Lounos on liansaclion cosls lhal ialionalizo oLsoivoo pailici-
palion ialos oi consumplion ano assol ioluins palloins can Lo founo in Mulligan ano Sala-i-Mailin
(2000) ano Vising-Joigonson (200S) oi Ho ano Mooosl (199), iospoclivoly. L.g., Mulligan ano
Sala-i-Mailin oslimalo lho poi-poiioo cosl of holoing any inloiosl-Loaiing assol lo Lo 111 oolalis
poi yoai.
16
Nolo lhal capilal accumulalion in ilsolf may ovoiluin lho 1ayloi piinciplo, al loasl in
conlinuous limo, as omphasizoo Ly Dupoi (2000). 1his woulo oLscuio oui papoi`s mossago.
17
1his funclion is in lho King-Ilossoi-IoLolo class ano loaos lo conslanl sloaoy-slalo houis.
10 FLOIIN O. LILLIIL
fiom lho olhoi assols oxplicilly sinco lhoii oisliiLulion plays a ciucial iolo in lho
iosl of lho analysis. 7
S,|
is Loginning of poiioo woallh, nol incluoing lho payol of
shaios. \
|
is lho maikol valuo al limo t of a shaio, 1
|
is ils ioal oivioono payol
ano \
S,|
aio shaio holoings.
ALsonco of aiLiliago implios lhal lhoio oxisls a slochaslic oiscounl facloi A
|,|l
such lhal lho piico al t of a poilfolio wilh uncoilain payol al t 1 is (foi slalo-
conlingonl assols ano shaios iospoclivoly):
(8.1) 1
S,|
= 1
|
[A
|,|l
7
S,|l
[ ano \
|
= 1
|
[A
|,|l
(\
|l
1
|l
1
|l
)[
Nolo lhal lho Luloi oqualion foi shaios iloialoo foiwaio givos lho funoamonlal piic-
ing oqualion: \
|
= 1
|
I=|l
A
|,I
1
I
1
I
.1ho iiskloss gioss shoil-loim nominal inloiosl
ialo 1
|
is a solulion lo:
(8.2)
1
1
|
= 1
|
A
|,|l
SuLsliluling lho no-aiLiliago conoilions (8.1) inlo lho woallh oynamics oqualion
givos lho low Luogol consliainl. 1ogolhoi wilh lho usual `naluial` no-Loiiowing
limil foi nh slalo, lhis will lhon imply lho usual inloilompoial Luogol consliainl:
(8.8) 1
|
I=|
A
|,I
1
I
C
S,I
_ 7
S,|
\
|
1
|
I=|
A
|,I
\
I
S,I
Maximizing ulilily suLjocl lo lhis consliainl givos lho lisl-oiooi nocossaiy ano
sumcionl conoilions al oach oalo ano in oach slalo:
,
l
c
(C
S,|l
)
l
c
(C
S,|
)
= A
|,|l
1
|l
1
|
0
S
,
:
S,|
=
1
C
S,|
\
|
1
|
along wilh (8.8) holoing wilh oqualily (oi alloinalivoly low Luogol consliainl holo
wilh oqualily ano liansvoisalily conoilions iuling oul ovoiacummulalion of assols
ano Ionzi gamos Lo salisloo: lim
I
1
|
[A
|,|I
7
S,|I
[ = lim
I
1
|
[A
|,|I
\
|I
[ = 0).
Using (8.8) ano lho funclional foim of lho ulilily funclion, lho shoil-loim nominal
inloiosl ialo musl oLoy:
1
1
|
= ,1
|
_
C
S,|
C
S,|l
1
|
1
|l
_
.
1ho iosl of lho housoholos on lho [0, `[ inloival havo no assols
18
: `nn-n
h|J:`. Ioasons foi lhis coulo incluoo consliainls of pailicipalion lo assol mai-
kols, myopia, oxliomo hypoiLolic oiscounling, limiloo infoimalion (whoioLy cuiionl
incomo is lho mosl salionl pioco of infoimalion), olc. Assuming foi inslanco as in
Apponoix 1 lhal lhoso housoholos faco a common, laigo onough piopoilional cosl
lo liaoo in assol maikols, lhoy will nol holo any assols. 1ho pioLlom of lho iopio-
sonlalivo non-assol holooi inooxoo Ly H is lhon oquivalonl lo:
(8.4) max
c
1t
,
1t
lnC
1,|
0
1
l,
1
1,|
1 ,
1
s.l. C
1,|
=
\
|
1
|

1,|
.
18
1hoso housoholos aio laLoloo `non-liaoois` Ly Alvaioz, Lucas ano WoLoi, ìulo-of-lhumL`
oi `non-Iicaioian` Ly GLV, ano `sponoois` Ly Mankiw 2000.
1ho lisl oiooi conoilion is:
(8.) 0
1
,
1
1,|
=
1
C
1,|
\
|
1
|
,
which fuilhoi allows :J&J-J:n |&.n foi C
1,|
ano
1,|
(funclions only of
\
|
,1
|
ano oxogonous piocossos). 1hoio is no nooo lo koop consumplion (oi mai-
ginal ulilily of incomo) of H conslanl, as lhis ooos nol oopono on saving oocisions
oi any olhoi inloilompoial foaluio. Nolo lhal ouo lo lho voiy foim of lho ulilily
funclion, houis aio conslanl foi lhoso agonls: lho ulilily funclion is choson lo oL-
lain conslanl houis in sloaoy slalo, ano lhis agonl is às if` sho woio in lho sloaoy
slalo always. In lhis caso laLoui supply of non-assol holoois is lxoo, no malloi
,
1
, as incomo ano suLslilulion olocls cancol oul. Whilo lhis facililalos algoLia, il
is in no way nocossaiy foi oui iosulls (olaslic laLoi supply will Lo oiscussoo Lolow).
Houis aio givon Ly:
1,|
= 0
l/(l,
1
)
1
ano consumplion will liack lho ioal wago
lo oxhausl lho Luogol consliainl. In lho iomainooi wo shall assumo wilhoul loss
of gonoialily lhal piofoioncos aio homogonous, i.o. ,
S
= ,
1
= ,. Coilain assump-
lions spolloo oul Lolow will imply lhal lho iolalivo woighls of lho oisulilily of woik
aio also oqual 0
S
= 0
1
.
3.2. FIrns. 1ho lims` pioLlom is complololy slanoaio ano can Lo skippoo
Ly somo ioaoois wilhoul loss of conlinuily. 1ho hnaI good is piooucoo Ly a
iopiosonlalivo lim using a CLS pioouclion funclion (wilh olaslicily of suLsli-
lulion -) lo aggiogalo a conlinuum of gooos inloimooialo inooxoo Ly i: 1
|
=
_
_
l
0
1
|
(i)
(:l)/:
di
_
:/(:l)
. Final gooo piooucois Lohavo compolilivoly, maximiz-
ing pioll 1
|
1
|

_
l
0
1
|
(i) 1
|
(i)di oach poiioo, whoio 1
|
is lho ovoiall piico in-
oox of lho lnal gooo ano 1
|
(i) is lho piico of inloimooialo gooo i. 1ho oo-
mano foi oach inloimooialo inpul is 1
|
(i) = (1
|
(i) ,1
|
)
:
1
|
ano lho piico inoox is
1
|
=
_
_
l
0
1
|
(i)
l:
di
_
l/(l:)
.
Lach inloimooialo gooo is piooucoo Ly a monopolisl inooxoo Ly i using a
lochnology givon Ly:
1
|
(i) =
|
|
(i) 1, if
|
(i) 1 ano 0 olhoiwiso.
1 is a lxoo cosl assumoo lo Lo common lo all lims: lhis will Lo a fioo paiamoloi
lhal can Lo choson such lhal piolls aio zoio in sloaoy slalo ano lhoio aio incioasing
ioluins lo scalo, consislonl wilh ovioonco Ly IolomLoig ano Wooofoio (100).
Alloinalivoly, if lho lxoo cosl is zoio, lhoio aio sloaoy-slalo piolls (which is lho
caso in GLV). Wo shall oncompass Lolh casos. Cosl minimizalion laking lho wago
as givon, implios lhal nominal maiginal cosl is 'C
|
= \
|
,
|
. 1ho pioll funclion
in ioal loims is givon Ly: 1
|
(i) = [1
|
(i),1
|
[ 1
|
(i)(\
|
,1
|
)
|
(i), which aggiogaloo
ovoi lims givos lolal piolls 1
|
= [1 ('C
|
,1
|
) ^
|
[ 1
|
. 1ho loim ^
|
is iolalivo
piico oispoision oolnoo following Wooofoio (2008) as ^
|
=
_
l
0
(1
|
(i) ,1
|
)
:
di ano
will play a majoi iolo in lho wolfaio analysis.
1o inlioouco a iolo foi monolaiy policy in alocling lho ioal allocalion in lhis
simplo cashloss moool wo follow Calvo (1088) ano Yun (1006) ano inlioouco slicky
piicos. Wo assumo lhal inloimooialo gooo lims aojusl lhoii piicos infioquonlly,
whoio 0 is lho pioLaLilily of kooping lho piico conslanl. 1his oxogonous pioLaLilily
is inooponoonl of hisloiy. Lach poiioo lho fiaclion of lims lhal koop lhoii piicos
unchangoo is also oqual lo 0 Ly lho law of laigo numLois. Shaioholoois maximizo
lho valuo of lho lim, i.o. lho oiscounloo sum of fuluio nominal piolls, using lho
iolovanl slochaslic oiscounl facloi A
|,|I
usoo as lho piicing koinol foi nominal
payols:
max
1t(I)
1
|
s=0
(0
s
A
|,|s
[1
|
(i)1
|,|s
(i) 'C
|I
1
|,|s
(i)[ ,
suLjocl lo lho oomano oqualion (al t :, conoilional upon piico sol : poiioos
in aovanco) 1
|,|s
(i) = (1
|
(i),1
|s
)
:
1
|s
.1ho oplimal piico of lho lim is lhon
founo as a maikup ovoi a woighloo avoiago of oxpocloo fuluio nominal maiginal
cosls:
1
o|
|
(.) = (1 j)1
|
s=0
c
|,|s
'C
|s
(8.6)
c
|,|s
=
0
s
A
|,|s
(1
|s
)
:l
1
|s
1
|
|=0
0
|
A
|,||
(1
||
)
:l
1
||
In oquiliLiium oach piooucoi lhal choosos a now piico 1
|
(i) in poiioo l will
chooso lho samo piico ano lho samo lovol oulpul. 1hon lho oynamics of lho piico in-
oox givon lho aggiogaloi aLovo is: 1
|
=
_
(1 0)1
o|
|
(i)
l:
01
|l
(i)
l:
_
l/(l:)
.
1ho comLinalion of lhoso lwo conoilions loaos in lho log-linoaiizoo oquiliLiium lo
lho woll known Now Koynosian Ihillips cuivo givon Lolow.
3.3. Aonetary oIIcy. Wo consiooi lwo policy fiamowoiks piominonl in lho
liloialuio. Fiisl, wo sluoy .n:&nn :&| in lho sonso of a foooLack iulo foi
lho insliumonl (shoil-loim nominal inloiosl ialo) as a funclion of macio vaiiaLlos,
mainly inlalion. Wo focus on iulos wilhin lho family (whoio vaiiaLlos wilh a slai
oonolo vaiiaLlos calculaloo unooi loxiLlo piicos, oolnoo Lolow):
(8.7) 1
|
= (1
|
)
1
_
1
|
1
|l
1
|
_
_
1
|
1
|
_
o
c
:t
.
Wo shall also consiooi laigoling iulos unooi oisciolionaiy policymaking, whoioLy
lho palh of lho nominal ialos is founo Ly oplimizalion Ly lho conlial Lank - lhis is
oosciiLoo in oolail in Soclion 6 Lolow. Such a fiamowoik will also imply a Lohavioial
iolalionship foi lho insliumonl iulo, Lul lhis is only an .n|.. .n:&nn :&|.
3.4. Aarket cIearIng, aggregatIon and accountIng. LaLoi ano gooos
maikol cloaiing imply iospoclivoly
|
= `
1,|
(1 `)
S,|
ano 1
|
= C
|
=
`C
1,|
(1 `) C
S,|
, whoio C
|
is aggiogalo consumplion. Slalo-conlingonl assols
aio in zoio nol supply, as is lho caso sinco maikols aio complolo ano agonls liaoing
in lhom aio ioonlical. Ly Walias` Law, lho oquily maikol cloais ano shaio holoings
of oach assol holooi aio lhon givon Ly:
\
S,|l
= \
S,|
= \ =
1
1 `
.
4. DynanIcs In tLe IInear|Ized| aggregate nodeI
Wo can loglinoaiizo lho oquiliLiium conoilions of lho aLovo moool aiouno lho
non-slochaslic sloaoy-slalo ano oxpioss oynamics in loims of aggiogalo vaiiaLlos
only, following similai slops as in Soclion 2 (soo Apponoix L foi oolails). 1his makos
oui moool ioaoily compaiaLlo wilh lho slanoaio full-pailicipalion fiamowoik (soo
CGG (1000), Wooofoio (2008)) ano amonaLlo lo policy oxoicisos. Wo lisl oxpioss
consumplion of assol holoois as a funclion of aggiogalo oulpul j
|
ano log oxogonous
lochnology a
|
:
c
S,|
= cj
|
(1 1
Y
) (1 c) a
|
, whoio c = 1 ,
`
1 `
1
1 j
,
j = (- 1)
l
is lho sloaoy-slalo nol maik-up ano 1
Y
lho shaio of lho lxoo cosl
in lolal oulpul in sloaoy slalo (ano lho oogioo of incioasing ioluins lo scalo). As
noloo Lofoio, consumplion of assol holoois can Lo iolaloo nogalivoly lo aggiogalo
oulpul (c < 0) whon pailicipalion is low oi laLoi supply is inolaslic onough, moio
piocisoly whon:
(4.1) ` `
=
1
1 ,, (1 j)
.
Consumplion of assol holoois can Lo nogalivoly iolaloo lo lolal oulpul sinco an
incioaso in oomano can only Lo salisloo Ly movomonls of (as opposoo lo movo-
monls along) lho laLoi supply schooulo whon onough pooplo holo no assols ano
laLoi supply is inolaslic onough. Lul lho nocossaiy iighlwaio shifl of laLoi sup-
ply can only como fiom a nogalivo incomo olocl on consumplion of assol holoois.
1his nogalivo incomo olocl is onsuioo in gonoial oquiliLiium Ly a n.n| fall in
oivioono incomo. Nolo lhal assol holoois havo in lhoii poilfolio (1 `)
l
shaios:
if lolal piolls foll Ly ono unil, oivioono incomo of ono assol holooi woulo fall Ly
(1 `)
l
1 unils
10
. 1ho n.n| oocioaso in piolls is a naluial iosull of inolas-
lic laLoi supply, sinco lho incioaso in maiginal cosl (ioal wago) woulo moio lhan
oulwoigh lho incioaso in salos (houis).
Howovoi, nolo lhal n&n| piolls may nol fall, piocisoly ouo lo lho nogalivo
incomo olocl making assol holoois willing lo woik moio; foi as a iosull of lhis olocl
houis will incioaso Ly moio ano maiginal cosl Ly loss. In facl, foi coilain comLina-
lions of paiamolois, shocks oi policios oui moool woulo n .n|j &n:j|.n|
:] in oquiliLiium (oi al loasl implios moio piocyclical piolls lhan a slanoaio
full-pailicipalion moool wilh counloicyclical maikups). 1his is an impoilanl poinl,
sinco il is wiooly Loliovoo lhal piolls aio piocyclical (soo Soclion 7 foi fuilhoi ois-
cussion). Il is also impoilanl lo nolo lhal lho nogalivo incomo olocl ooos nol moan
lhal foi a givon incioaso in oulpul, lho consumplion of assol holoois will nocossaiily
J:n. In facl, if lho incioaso in oulpul is ouo lo lochnology, c
S
will .n:n in
mosl casos (i.o. whon lho oquiliLiium olaslicily of oulpul lo lochnology is loss lhan
(1 j)
_
1 c
l
_
).
Wo call `nn-1jn.nn` an oconomy in which pailicipalion in assol maikols is
limiloo onough such lhal c < 0, sinco as noloo Lofoio in Soclion 2 incioasos in ioal
inloiosl ialos aio oxpansionaiy (soo Figuio 1). Il is oLvious lhal lho only way foi
10
In lho slanoaio moool all agonls holo assols, so lhis mochanism is complololy iiiolovanl.
Any incioaso in wago oxaclly componsalos lho oocioaso in oivioonos, sinco all oulpul is consumoo
Ly assol holoois.
c lo Lo inooponoonl of ` is foi , lo Lo zoio, i.o. laLoi supply of assol holoois Lo
inlniloly olaslic. In lhis caso, consumplion of all agonls is inooponoonl of woallh,
making lho holoiogonoily inliooucoo in lhis papoi iiiolovanl.
Having oxpiossoo consumplion of assol holoois as a funclion of aggiogalo oul-
pul, wo can now suLslilulo il Lack inlo lho Luloi oqualion ano lno an aggiogalo
Luloi oqualion, oi ÌS cuivo`:
(4.2) r
|
= 1
|
r
|l
c
l
[r
|
1
|
|l
r
|
[
In (4.2) wo usoo lho oulpul gap r
|
= j
|
j
|
ano `naluial` lovols of oulpul j
|
ano inloiosl ialos r
|
, calculaloo unooi loxiLlo piicos as funclions of lochnology:
j
|
=
_
1 1
Y
_
1
l
_
a
|
; r
|
= [1 1
Y
(1 c,)[ [1
|
a
|l
a
|
[ ,
whoio = 1 ,
_
1
`
1 `
1
Y
_
, (1 1
Y
) _ 1 _ c,
ano 1
Y
= (j 1
Y
) , (1 j) is lho shaio of piolls in sloaoy slalo oulpul. Nolo
lhal poimanonl lochnology shocks havo poimanonl olocls on naluial oulpul ano
posilivo lompoiaiy olocls on lho naluial inloiosl ialo sinco c < (whoioas lom-
poiaiy lochnology shocks causo a fall in r
|
). Following lho oiscussion aLovo, nolo
lhal unooi loxiLlo piicos, consumplion of assol holoois will always incioaso in io-
sponso lo lochnology shocks, oospilo ils pailial olaslicily lo lolal oulpul c Loing
nogalivo. In facl, consumplion of assol-holoois unooi loxiLlo piicos is solvoo as
c
S,|
= [1 1
Y
(1 c,)[ a
|
ano is piocyclical. Ioal piolls unooi loxiLlo piicos aio
givon Ly d
|
= [j, (1 j)[ j
|
, ano aio also piocyclical.
Diiocl inspoclion of (4.2) suggosls lho impacl lhal LAMI has on lho oynamics
of a slanoaio Lusinoss cyclo moool lhiough mooifying lho olaslicily of aggiogalo
oomano lo ioal inloiosl ialos c
l
in a non-linoai way. Foi high onough pailicipa-
lion ialos ` < `
(whoio lho lalloi is givon Ly (4.1)) wo aio in a `Koynosian` iogion,

whoioLy ioal inloiosl ialos iosliain aggiogalo oomano. As ` incioasos lowaios `
,
lho sonsilivily lo inloiosl ialos incioasos in aLsolulo valuo, making policy moio of-
foclivo in conlaining oomano. Howovoi, onco ` is aLovo lho lhiosholo `
wo movo
lo lho `non-Koynosian` iogion whoio incioasos in ioal inloiosl ialos Locomo oxpan-
sionaiy (soo also Figuio 1). As ` lonos lo ils uppoi Louno of 1, c
l
oocioasos
lowaios zoio - policy is inoloclivo whon noLooy holos assols.
Log-linoaiizalion of lho piicing oqualions loaos lo a Ihilips cuivo iolaling in-
lalion lo oxpocloo inlalion ano oulpul gap vaiialions:
(4.8)
|
= ,1
|
|l
cr
|
n
|
, whoio c = (1 0) (1 0,) ,0
Following o.g. Claiioa, Gal ano Goilloi (1000) wo inlioouco `cosl-push` shocks
n
|
, i.o. vaiialions in maiginal cosl nol ouo lo vaiialions in oxcoss oomano
20
. 1ho
aggiogalo supply sioo in (4.8) oilois fiom lho slanoaio fiamowoik only insofai
as lho piosonco of non-assol holoois mooilos (lho olaslicily of maiginal cosl lo
movomonls in lho oulpul gap) ano honco lho iosponso of inlalion lo aggiogalo
oomano vaiialions. Howovoi, wilh incioasing ioluins lo scalo of a oogioo making
sloaoy-slalo piolls zoio j = 1
Y
, lho Ihilips cuivo is nol inluoncoo Ly lho piosonco
of LAMI. IolomLoig ano Wooofoio (100) mako a sliong caso foi such a oogioo of
20
1hoso coulo como fiom lho oxislonco of slicky wagos cioaling a limo-vaiying wago maikup,
a limo-vaiying olaslicily of suLslilulion among inloimooialo gooos oi olhoi souicos cioaling lhis
inomcioncy woogo Lolwoon lho omcionl ano naluial lovols of oulpul (o.g. oisloilionaiy laxalion).
Foi oolails as lo whal lhoso limo-vaiying woogos coulo Lo, soo Wooofoio (2008, Ch. 6).
incioasing ioluins. Wo assumo lhal lochnology giowlh (â
|
= a
|
a
|l
) is givon
Ly an AI(1) piocoss â
|
= j
o
â
|l
-
o
|
, which implios shocks lo lochnology havo
poimanonl olocls (soo Gal (1000)).
IaraneterIzatIon Wo shall now havo a lisl glanco al lho magniluoo of `
ioquiioo foi oui iosulls lo holo quanlilalivoly. 1o lhal ono wo paiamoloiizo lho
moool al quailoily fioquoncy; lho Lasolino caso follows GLV (oxcopl foi lho mon-
lionoo oiloioncos) ano mosl monolaiy policy sluoios. Namoly, wo sol lho oiscounl
facloi , such lhal r = 0.01, lho sloaoy slalo maikup j = 0.2 coiiosponoing lo an
olaslicily of suLslilulion of inloimooialo gooos of 6. 1ho lxoo cosl paiamoloi (ano
oogioo of incioasing ioluins lo scalo) is sol lo oilhoi 0 (sloaoy-slalo piolls) oi 1
Y
=
j = 0.2. 1ho avoiago piico ouialion is ono yoai, implying 0 = 0.7. As lo paia-
moloiizing laLoui, lhis is somohow moio oolicalo, foi lhoio is no oala lo lho Losl
of oui knowloogo oisonlagling vaiious piofoioncos foi loisuio, oi oquivalonlly houis
woikoo, as a funclion of woallh. Sinco wo havo no piiois foi assuming olhoiwiso, wo
assumo lhal Lolh lypos woik lho samo houis in sloaoy slalo =
S
=
1
= 1,8
(as commonly assumoo in lho liloialuio). Iocall lhal lho olaslicily of lho maiginal
oisulilily of laLoi lo laLoi , is homogonous acioss gioups. 1hon, if sloaoy-slalo
assol incomo is zoio (piolls aio zoio), consumplion shaios aio oqual acioss gioups
C
1
= C
S
= C ano honco piofoioncos foi loisuio aio also homogonoous 0
1
= 0
S
21
Apail fiom ,, wo also consiooi oiloionl valuos foi lho shaio of non-assol holoois
` sinco lhis is pioLaLly oui mosl conliovoisial paiamoloi - ompiiical ovioonco Ly
CampLoll ano Mankiw (1080) suggosls lhis is aiouno 0.4-0. foi lho US oconomy.
In Figuio 2 wo plol lho lhiosholo ` as a funclion of ,, such lhal valuos unooi
lho cuivo givo lho c 0 caso, whoioas aLovo lho cuivo wo havo lho non-Koynosian
oconomy wilh c < 0.
0.2
1
0 5 10 15 20 25 30
0.5
0.8
Non-Keynesian economy region
Fig. 2: 1hiosholo shaio of non-assol holoois as a funclion of invoiso laLoi supply
olaslicily. ALovo lho lhiosholo wo havo lho `LAMI oconomy` whoio lho Invoiloo 1ayloi
Iiinciplo applios.
Foi Koynosian logic lo woik, lho Fiisch olaslicily of laLoi supply (ano of inloilom-
poial suLslilulion in laLoi supply), shoulo Lo high, ano lho highoi, lho highoi lho
shaio of non-assol holoois `. Foi a iango of , Lolwoon 1 (unil olaslicily) ano 10
(0.1 olaslicily) lho lhiosholo shaio of non-assol holoois shoulo Lo lowoi lhan 0. lo
as low as aiouno 0.1 iospoclivoly. 1his shows lhal lho ioquiioo shaio of non-assol
holoois lo ono up in lho non-Koynosian caso is nol lhal laigo.
21
If insloao sloaoy-slalo assol incomo is posilivo (whon foi inslanco lhoio aio non-zoio piolls
in sloaoy-slalo), sloaoy-slalo consumplion shaios aio oiloionl. In lhal caso, piofoioncos foi loisuio
will Lo oiloionl acioss housoholos 0
1
< 0
S
: assol holoois nooo lo oisliko laLoi loss in oiooi lo
woik lho samo houis as non-assol holoois in sloaoy-slalo.
4.1. FurtLer IntuItIon - tLe IaLor narket. 1ho koy lo unooislanoing lho
iosulls oLlainoo hoio is lho laLoi maikol oquiliLiium. In syslom (4.4) wo oullino lho
laLoi supply ano lho oquiliLiium wago-houis locus. 1ho laLoi supply schooulo 1o
iopiosonls lho locus of wagos ano houis foi a givon lovol of consumplion of assol
holoois (all lho inloilompoial suLslilulion in laLoi supply comos naluially fiom
assol holoois). 1ho oquiliLiium wago-houis locus laLoloo \ is ooiivoo laking
inlo accounl all oquiliLiium conoilions, mosl nolaLly how consumplion is iolaloo
lo ioal wago in oquiliLiium. 1his schooulo is invaiianl lo onoogonous foicos in
oquiliLiium (in facl, il will Lo shifloo Ly lochnology shocks only).
1o : n
|
= ,
1
1 `
:
|
c
S,|
(4.4)
\ : n
|
=
_
(1 1
Y
) c ,
1
1 `
_
:
|
(1 1
Y
) a
|
A `non-Koynosian oconomy` (c < 0) has an inluilivo inloipiolalion in laLoi maikol
loims, foi il implios lhal lho oquiliLiium wago-houis locus is loss upwaio sloping
lhan (ano honco culs fiom aLovo) lho laLoi supply cuivo. Inluilivoly, lho piosonco
of non-assol holoois gonoialos ovoiall a `nogalivo incomo olocl`, which cannol Lo
oLlainoo coloiis paiiLus whon ` = 0 ano c = 1. In lho lalloi, slanoaio caso, lho
wago-houis locus is moio upwaio sloping lhan LS. 1ho oiloionco Lolwoon lho lwo is
lho inloilompoial olaslicily of suLslilulion in consumplion, noimalizoo lo 1 in oui
caso (mulliplioo Ly ioluins lo scalo 11
Y
). Coloiis paiiLus, if lho laLoi oomano
shifls oul, laLoi supply shifls loflwaio ouo lo lho usual incomo olocl, sinco agonls
anlicipalo highoi incomo ano highoi consumplion. If laLoi supply shifls up ouo
lo a posilivo incomo olocl, samo olocl makos laLoi oomano shifl oul. 1his givos
a WN locus moio upwaio sloping lhan lho laLoi supply cuivo LS. 1ho lhiosholo
valuo foi ` foi lhis insighl lo chango is lho samo as lhal making c < 0 ano givon in
(4.1) aLovo. Whon lho shaio of non-assol holoois is highoi lhan lhis lhiosholo (oi
oquivalonlly foi a givon shaio, laLoi supply of assol holoois is inolaslic onough), lho
wago-houis locus Locomos loss upwaio sloping lhan lho laLoi supply. An inluilion
foi lhal follows, as illuslialoo in Figuio 8 whoio wo assumo lhal lho ioal inloiosl
ialo is kopl conslanl foi simplicily
22
.
1ako lisl an oxogonous oulwaio h.J .n |nh: JnnnJ. Kooping supply lxoo,
lhoio woulo Lo an incioaso in ioal wago ano an incioaso in houis. 1ho incioaso in
lho ioal wago woulo Loosl consumplion of non-assol holoois, amplifying lho inilial
oomano olocl. Whon laLoi supply is iolalivoly inolaslic, lhis incioaso in wago is
laigo ano lho incioaso in houis is small compaioo lo lhal nocossaiy lo gonoialo
lho oxlia oulpul oomanooo; nolo lhal lho olocl inoucoo on oomano is laigoi, lho
highoi lho shaio of non-assol holoois. 1ho only way foi supply lo mool oomano is
foi laLoi supply lo shifl iighl. 1his is insuioo in oquiliLiium Ly lho polonlial fall
in piolls iosulling fiom: (i) incioasing maiginal cosl (sinco wago incioasos) ano (ii)
lho woak incioaso in houis ano honco in oulpul ano salos. 1his is liko ano inoiiocl
nogalivo incomo olocl inoucoo on assol holoois Ly lho piosonco of non-assol holoois.
Noxl consiooi a h.J .n |nh: &|j, foi oxamplo loflwaio as woulo Lo lho caso if
consumplion of assol holoois incioasoo. Kooping oomano lxoo, wago incioasos ano
houis fall. 1ho incioaso in wago (ano lho incioaso in consumplion of assol holoois
22
How lho nominal inloiosl ialo ioacls lo inlalion, gonoialoo hoio Ly vaiialions in oomano,
will Lo ciucial in lho fuilhoi analysis.
ilsolf) has a oomano olocl ouo lo slicky piicos. As laLoi oomano shifls iighl, lho
ioal wago woulo incioaso Ly ovon moio; houis woulo incioaso, Lul Ly lilllo ouo
lo lho iolalivoly inolaslic laLoi supply (lho ovoiall olocl woulo again oopono on
lho iolalivo slopos of lho lwo cuivos). 1ho incioaso in lho ioal wago moans oxlia
oomano lhiough non-assol holoois` consumplion
28
. 1o mool lhis oomano, only way
foi incioasing oulpul is an incioaso in laLoi supply, which insloao oLlains only if
laLoi supply shifls iighl, which is insuioo as Lofoio Ly lho polonlial fall in piolls.
1his oxplains why in a `nn-1jn.nn nnj` lho wago-houis locus culs lho
laLoi supply cuivo fiom aLovo. 1his insloao will holp oui inluilion in oxplaining
lho fuilhoi iosulls
24
. Nolo lhal such a wago-houis locus implios lhal lho moool
gonoialos a highoi pailial olaslicily of houis lo lho ioal wago, ano moio so moio
nogalivo c is.
w-p
n
I
K
A
NK
0
Ls
Ls1
Ls2
Ld
Ld1
Ld2
(w,n)
e
Fig. 8: 1ho oquiliLiium wago-houis locus ano laLoi supply cuivo wilh LAMI.
Having ooiivoo lho oquiliLiium wago-houis locus givos us a simplo way of lhink-
ing inluilivoly aLoul lho olocls of shocks ano of monolaiy policy in gonoial; mon-
olaiy policy, Ly changing nominal inloiosl ialos, mooilos ioal inloiosl ialos ano
honco shifls lho laLoi supply cuivo (Ly changing lho inloilompoial consumplion
piollo of assol holoois). Lul lhis has no olocl on lho wago-houis locus Ly con-
sliuclion, sinco lhis oosciiLos a iolalionship lhal holos in oquiliLiium always ano
is shifloo only Ly lochnology shocks.
4.2. HoLustness. Ono mighl iighlly wonooi wholhoi lho moio lhooiolical
possiLilily of a chango in lho sign of c is onliioly ooponoonl upon lho spocilcalion
of piofoioncos. Il luins oul lhis possiLilily is ioLusl lo lwo oLvious canoioalos:
28
1ho assumplions on piofoioncos onsuiing conslanl sloaoy-slalo houis aio loss ciucial lhan
il mighl soom. Lolow wo consiooi alloinalivo piofoionco spocilcalions.
24
Nolo lhal lho inluilion foi ioal inooloiminacy lo oLlain in slanoaio moools (soo o.g. Lon-
haLiL ano Faimoi 1004) ioquiios lho wago houis locus Lo upwaio sloping Lul cul lho laLoi supply
cuivo fiom h|&. 1his is also lho caso in slanoaio slicky-piico moools, ano givos iiso lo a coilain
ioquiiomonl foi lho monolaiy policy iulo lo iosull inlo ioal ooloiminacy - soo Lolow. Oui inluilion
will Lo lhal having lho wago-houis locus cul lho laLoi suply fiom nh, changos ooloiminacy
piopoilios in a coilain way.
an olaslic laLoi supply of non-assol holoois, ano a non-unilaiy olaslicily of in-
loilompoial suLslilulion in consumplion. Foi complolion, wo Liioly sluoy lhoso
oxlonsions joinlly. Consiooi piofoioncos givon Ly a gonoial CIIA ulilily funclion
foi Lolh agonls , ( is iolalivo iisk avoision foi Lolh agonls ano also invoiso of
inloilompoial olaslicily of suLslilulion in consumplion foi assol holoois):
(4.) l
(., .) =
C
l~
,|
1
0
l,
,|
1 ,
Following lho samo molhoo as Lofoio ono can show lhal lho solulion lo non-assol
holoois` pioLlom will Lo (in log-linoaiizoo loims, whoio olaslicily of houis lo wago
j = (1 ) , ( ,) is posilivo il < 1):
(4.6) :
1,|
= jn
|
; c
1,|
= (1 j) n
|
Foi assol holoois, lho now Luloi oqualion ano inlialompoial oplimalily in log-
linoaiizoo foim aio:
1
|
c
S,|l
c
S,|
=
l
(r
|
1
|
|l
) (4.7)
,:
S,|
= n
|
c
S,|
(4.8)
Using lho samo molhoo as pioviously, ono lnos lhal lho now conoilion lo Lo fulllloo
in oiooi foi c lo Locomo nogalivo ano honco ono up in a `non-Koynosian oconomy`:
(4.0) `
1
1 ,(1 jj) , (1 j)
Ly compaiing (4.0) wilh (4.1) ono immooialoly nolicos lhal unooi lho moio gonoial
piofoioncos (4.) lho lhiosholo valuo of ` is lowoi (highoi) lhan unooi log ulilily
if j 0 (< 0). 1ho inluilion is lhal whilo making aggiogalo laLoi supply moio
olaslic, a posilivo j also makos j&.|.h:.&n houis moio olaslic lo wago changos
sinco il makos consumplion of non-assol holoois moio iosponsivo lo lho wago. In
gonoial howovoi, lho oiloionco inoucoo Ly having ,= 1 on lho lhiosholo valuo of
` is quanlilalivoly nogligiLlo
2
. In viow of lho iolalivo innocuousnoss of lhoso as-
sumplions, wo shall conlinuo using lho log-CIIA ulilily funclion in lho iomainooi,
sinco il piosoivos conslanl sloaoy-slalo houis ano honco allows analyzing poimanonl
lochnology shocks.
5. TLe Inverted TayIor IrIncIIe: DeternInacy roertIes oI Interest
rate ruIes
In lhis Soclion wo sluoy ooloiminacy piopoilios of simplo inloiosl ialo iulos
26
.
Wo lisl consiooi iulos involving a iosponso lo oxpocloo inlalion, as oono foi ox-
amplo Ly CGG (2000). 1his spocilcalion piovioos simploi (shaipoi) ooloiminacy
conoilions, ano capluios lho iooa lhal lho conlial Lank iosponos lo a laigoi sol of
infoimalion lhan moioly lho cuiionl inlalion ialo:
(.1) r
|
= c
t
1
|
|l
-
|
whoio -
|
is lho non-syslomalic pail of policy-inoucoo vaiialions in lho nominal ialo.
1ho oynamic syslom foi lho .
|
= (r
|
,
|
)
vocloi of onoogonous vaiiaLlos ano lho

2
Lvon ovalualing lho oiloionco Lolwoon lho lhiosholo valuos coiiosponoing lo = 0 ano
100 iospoclivoly, ono oLlains unooi lho Lasolino paiamoloiizalion (foi valuos of , = 0.; 1; ; 10
iospoclivoly): 0.18;0.00; 0.08; 0.01.
26
Foi analylical simplicily wo aLsliacl fiom inoilia (inloiosl ialo smoolhing) Lul lhis oxlon-
sion shoulo Lo sliaighlfoiwaio.
i
|
= (-
|
r
|
, n
|
)
vocloi of oisluiLancos is oLlainoo Ly ioplacing (.1) inlo (4.2)

ano (4.8) as:
1
|
.
|l
= .
|
wi
|
,
whoio coomcionl maliicos aio givon Ly:
=
_
1 ,
l
c
l
i(c
t
1) c
l
,
l
(c
t
1)
,
l
i ,
l
_
, (.2)
w =
_
c
l
,
l
c
l
(c
t
1)
0 ,
l
_
.
Sinco Lolh inlalion ano oulpul gap aio foiwaio-looking vaiiaLlos, ooloiminacy
ioquiios lhal Lolh oigonvaluos of Lo oulsioo lho unil ciiclo. 1ho ooloiminacy
piopoilios of iulo (.1) aio omphasizoo in Iioposilion 2 (lho pioof is in Apponoix
C).
Inoioi1io: 1. 3lc 1urcrIcu 3uIor 1r1uc1Ic: 1nJ: |.j :&| ;.1)
h: r. n |n||j &n.j& :n.nn| rn.n j&.|.h:.&n ;... h j&.|.h:.&n
. J:n.nn) .J nnJ n|j .J:
n 1: 1hn c 0 : c
t

_
1, 1 c
2(lo)
r
_
;
n 11: 1hn c < 0 : c
t

_
1 c
2(lo)
r
, 1
_
[0, ) .
Caso I coiiosponos lo lho slanoaio `Koynosian` caso: lho 1ayloi piinciplo
(Wooofoio (2001)) is al woik: as noloo in lho piovious liloialuio lho conlial Lank
shoulo iospono moio lhan ono-lo-ono lo incioasos in inlalion
27
. Caso II is lho
`non-Koynosian oconomy`. In lhis caso, lho Conlial Lank shoulo follow an 1n:J
Jnj|: 1:.n.|: only passivo policy is consislonl wilh a uniquo ialional oxpoc-
lalions oquiliLiium. OLviously, lho conoilion foi lho 1n:J Jnj|: 1:.n.| lo
holo is lho samo as lho ono causing a chango in lho sign of c, as in (4.1).
5.1. IntuItIon: sunsot equIIILrIa vItL LAAI. An inluilivo oxplanalion
of Iioposilion 1 is in oiooi. Wo will oiscuss inluilion as lo why in casos covoioo Ly
lho Iioposilion sunspol shocks havo no ioal olocl, whoioas in lho opposilo casos
lhoy loao lo solf-fulllling oxpoclalions. In Soclion 7 Lolow wo will compulo sunspol
oquiliLiia foimally. Nolo lhal Ly suLsliluling lho iulo (.1) inlo (4.2) wo oLlain
aggiogalo oomano as a funclion of oxpocloo inlalion:
(.8) r
|
1
|
r
|l
= c
l
(c
t
1) 1
|
|l
.
Supposo foi simplicily ano wilhoul losing gonoialily lhal a sunspol shock hils
inlalionaiy oxpoclalions. In a An-1jn.nn nnj (c < 0) a non-funoamonlal
incioaso in oxpocloo inlalion gonoialos an incioaso in lho oulpul gap looay if lho
policy iulo is aclivo (c
t
1) as can Lo soon fiom (.8). Ly lho Ihilips cuivo
inlalion looay incioasos, valioaling lho inilial non-funoamonlal oxpoclalion. 1his
is nol lho caso in lho Koynosian oconomy (c 0), sinco an aclivo iulo gonoialos a
fall in oulpul gap ano (Ly Ihilips cuivo logic) aclual inlalion, conliaoicling inilial
oxpoclalions.
How ooos a passivo policy iulo onsuio oquiliLiium ooloiminacy whon c < 0
A non-funoamonlal incioaso in oxpocloo inlalion causos a fall in lho ioal inloiosl
ialo, a fall in lho oulpul gap looay Ly (.8) ano oolalion, conliaoicling lho inilial
27
Il shoulo also nol iospono `loo much`, which is a woll-oslaLlishoo iosull lisl noloo Ly
Loinako ano Wooofoio (1007).
oxpoclalion lhal aio honco nol solf-fulllling. Al a moio micio lovol, lho liansmission
is as follows. 1ho fall in lho ioal ialo loaos lo an incioaso in consumplion of assol
holoois, ano an incioaso in lho oomano foi gooos; Lul nolo lhal lhoso aio now
pailial olocls. 1o woik oul lho ovoiall olocls ono nooos lo look al lho compononl
of aggiogalo oomano coming fiom non-assol holoois ano honco al lho laLoi maikol.
1ho pailial olocls ioonliloo aLovo woulo causo an incioaso in lho ioal wago (ano
a fuilhoi Loosl lo consumplion of non-assol holoois) ano a fall in houis. Incioasoo
oomano, howovoi, moans lhal (i) somo lims aojusl piicos upwaios, Liinging aLoul
a fuilhoi fall in lho ioal ialo (as policy is passivo); (ii) lho iosl of lims incioaso
laLoi oomano, ouo lo slicky piicos. Nolo lhal lho ioal ialo will Lo falling along lho
onliio aojuslmonl palh, amplifying lhoso olocls. Lul sinco lhis woulo lianslalo inlo
a high incioaso in lho ioal wago (ano maiginal cosl) ano a low incioaso in houis, il
woulo loao lo a fall in piolls, ano honco a nogalivo incomo olocl on laLoi supply.
1ho lalloi will lhon nol movo, ano no inlalion will iosull, iuling oul lho olocls of
sunspols. 1his happons whon assol maikols pailicipalion is limiloo ònough` in a
way maoo oxplicil Ly (4.1).
If lho policy iulo is insloao aclivo ; c
t
1) sunspol oquiliLiia can Lo con-
sliucloo. 1ho shock lo inlalionaiy oxpoclalions loaos lo an incioaso in lho ioal
ialo ano in aggiogalo oomano Ly (.8). 1his gonoialos inlalion ano makos lho
inilial oxpoclalions solf-fulllling. Al a micio lovol, liansmission is as follows: con-
sumplion of assol holoois incioasos ouo lo lho ioal ialo incioaso, which implios
a iighlwaio shifl of laLoi supply, ano honco a fall in wago ano incioaso in houis.
Consumplion of non-assol holoois also falls ono-lo-ono wilh lho wago, ano honco ag-
giogalo oomano falls Ly moio lhan il woulo in a full-pailicipalion oconomy. Fiims
who can aojusl piicos will aojusl lhom oownwaios, causing oolalion, ano a fuilhoi
fall in lho ioal ialo. Fiims who cannol aojusl piicos will cul oomano, causing a fui-
lhoi fall in lho ioal wago ano a small fall in houis (sinco laLoi supply is inolaslic).
Lul lhis will moan highoi piolls (sinco maiginal cosl is falling), ano ovonlually
a posilivo incomo olocl on laLoi supply of assol holoois. As laLoi supply slails
moving loflwaio, oomano slails incioasing, ils incioaso Loing ampliloo Ly lho son-
silivily of non-assol holoois lo wago incioasos. 1ho oconomy will oslaLlish al a
poinl on lho wago-houis locus consislonl wilh lho ovoiall nogalivo incomo olocl on
laLoi supply of assol holoois, i.o. wilh highoi inlalion ano ioal aclivily. Honco,
lho inilial inlalionaiy oxpoclalions Locomo solf-fulllling.
5.2. Outut staLIIIzatIon restores tLe TayIor IrIncIIe. Following lho
inluilion al lho ono of Soclion 2, wo now sluoy how a policy iulo incoipoialing an
oulpul slaLilizalion molivo can mako lho 1ayloi piinciplo a gooo policy piosciip-
lion ovon in a `non-Koynosian oconomy` whoio c < 0. In conliasl lo lho simplo
fiamowoik consiooioo oailioi, lhoio aio non-liivial inloiaclions among paiamolois
ouo lo lho naluio of lho piico-aojuslmonl oqualion. Consiooi a iulo of lho foim:
(.4) r
|
= c
t
1
|
|l
c
r
r
|
,
whoioc
r
is lho iosponso lo oulpul gap. Ioplacing lhis inlo (4.2) ano (4.8), lho
maliix Locomos:
=
_
1 c
l
_
,
l
i(c
t
1) c
r
c
l
,
l
(c
t
1)
,
l
i ,
l
_
Applying oxaclly lho samo molhoo as in lho pioof of Iioposilion 1 il can Lo
shown lhal lho ooloiminacy conoilions aio as follows.
Inoioi1io: 2. ;n) 1nJ: ;.), h: r. n |n||j &n.j& :n.nn| r-
n.n j&.|.h:.&n .J nnJ n|j .J:
n 1: 1hn c 0 : c
t
lo
r
c
r
1 nnJ c
t
< 1
lo
r
(c
r
2c) ;h `Jnj|:
1:.n.|`)
n 11: 1hn c < 0 : 11J111
11.: c
r
< c (1 ,) nnJ c
t

1 ,
i
c
r
< 1 nnJ c
t
1
1 ,
i
(c
r
2c)
O1
11.1: c
r
c (1 ,) nnJ c
t

1 ,
i
c
r
1 nnJ c
t
< 1
1 ,
i
(c
r
2c)
;h) Jh j&.|.h:.&n . .nJ:n.nn :jn:J| J c
t
.J c < 0 nnJ c
r

(c (1 ,) ; c (1 ,)) .
Iail (a) sluoios oquiliLiium uniquonoss. Caso I is lho slanoaio 1ayloi piinciplo
foi an oconomy whoio c 0. In conliasl lo Iioposilion 1, in Caso II lho invoision of
lho 1ayloi Iiinciplo is now n gianloo. If oilhoi c is voiy laigo in aLsolulo valuo (a
high oogioo of limiloo pailicipalion `) oi lho iosponso lo oulpul is low, wo ono up
in caso II.A ano an inslanco of lho Invoiloo 1ayloi Iiinciplo is oLsoivoo. Howovoi,
foi moooialo valuos of ` anooi a high onough iosponso lo lho oulpul gap, lho
1ayloi Iiinciplo is iosloioo. Anolhoi way lo pul lhis is lhal foi a givon shaio of
non-assol holoois, lho 1ayloi Iiinciplo is a gooo guioo foi policy only insofai as lho
iosponso lo oulpul is high onough. 1ho iosponso lo oulpul, howovoi, can gonoialo
poivoiso olocls if il is nol high onough ano pailicipalion lo assol maikols is voiy
limiloo. As pail (L) of lho Iioposilion shows, lho oquiliLiium is inooloiminalo if
c
r
is in a coilain iango, iogaioloss of lho magniluoo of lho inlalion iosponso. 1his
iogion is incioasing wilh lho shaio of non-assol holoois.
1o assoss lho magniluoo of lho policy coomcionls nooooo foi iosloiing lho 1ay-
loi piinciplo, consiooi lho olhoiwiso Lasolino paiamoloiizalion foi a `non-Koynosian
oconomy` wilh ` = 0.4 ano , = 2 giving c = 0.11 ano i = 0.228 .1ho conoilions
foi Caso II.L aio c
r
0.21 ; c
t
10.048c
r
; c
t
< 8. 728 c
r
0.020 16.1ho lguio
Lolow shows lhal as soon as lho Conlial Lank iosponos lo oulpul, lho 1ayloi piin-
ciplo is iosloioo unooi lho Lasolino paiamoloiizalion foi a laigo paiamoloi iogion.
Howovoi, lhis iosull shoulo Lo lakon wilh caio, foi lho voiy oangois associaloo wilh
iosponoing lo oulpul mighl oulwoigh polonlial Lonolls. As soon as lho shaio of
non-assol holoois incioasos oi laLoi supply Locomos moio inolaslic, oquiliLiium is
moio likoly lo Locomo inooloiminalo foi any inlalion iosponso. In lhal caso, il
sooms aovisaLlo nol lo iospono lo lho oulpul gap.
2 1.5 1 0.5 0
4
3
2
1
x
Taylor Principle Restored

Fig. 4 : Iolicy paiamoloi iogion whoioLy 1ayloi Iiinciplo is iosloioo in a `LAMI
oconomy` Ly iosponoing lo oulpul unooi Lasolino paiamoloiizalion.
Finally, in Apponoix C wo show lhal a voision of lho 1n:J Jnj|: 1:.n.|
holos foi a conlompoiaiy iulo also. 1his is oono lo fuilhoi illuslialo lho oiloioncos
of oui ooloiminacy iosulls fiom GLV (2008/), whoio lhoio is a oiamalic oislinclion
Lolwoon foiwaio-looking ano conlompoianoous iulos. GLV oo nolo (iolying upon
numoiical simulalions ano nol as a gonoial iosull) a iosull similai lo oui Iioposilion
2: namoly, lho 1ayloi piinciplo may nooo lo Lo violaloo foi a foiwaio-looking iulo,
ano only foi a high shaio of non-assol holoois. Lul foi a conlompoianoous iulo lo Lo
compaliLlo wilh a uniquo oquiliLiium, lhoy aiguo lhal lho conlial Lank shoulo io-
spono lo inlalion moio sliongly lhan in lho full-pailicipalion oconomy (ano inoooo
voiy sliongly unooi somo paiamoloi conslollalions). 1ho mossago of oui papoi in
whal iogaios ooloiminacy piopoilios of policy iulos is oiloionl: wo piovioo analyl-
ical conoilions foi an invoiloo 1ayloi piinciplo lo holo gonoiically, inooponoonlly
on lho policy iulo followoo. Oui iosulls foi a simplo 1ayloi iulo havo lho samo
lavoi as foi a foiwaio-looking iulo: in lho `non-Koynosian oconomy` lho invoiloo
1ayloi piinciplo holos `gonoiically` (i.o. if wo oxcluoo somo oxliomo valuos foi somo
of lho paiamolois) foi a somowhal laigoi shaio of non-assol holoois lhan was lho
caso unooi a foiwaio-looking iulo. Il is also lho caso, as in GLV, lhal a policy
iulo iosponoing lo cuiionl inlalion voiy sliongly woulo insuio oquiliLiium uniquo-
noss
28
. Lul lho implioo iosponso (c
t
= 8 unooi lho Lasolino paiamoloiizalion):
(i) is much laigoi lhan any plausiLlo ompiiical oslimalo; (ii) woulo imply lhal zoio
Louno on nominal inloiosl ialos Lo violaloo foi ovon small oolalions; (iii) woulo
havo lilllo ciooiLilily. 1his is in conliasl wilh GLV, who oo nol consiooi a possiLlo
invoision of lho 1ayloi piinciplo in lhoii numoiical analysis of such iulos, Lul in-
sloao aiguo lhal foi a laigo shaio of non-assol holoois making lho ioquiioo policy
iosponso loo sliong unooi a 1ayloi iulo, lho conlial Lank shoulo swilch lo a passivo
foiwaio-looking iulo.
6. OtInaI nonetary oIIcy {vLen tLe steady-state Is ecIent).
1ho aLovo analysis suggosls lhal in an oconomy wilh limiloo pailicipalion
in assol maikols, lho conlial Lank following an aclivo iulo woulo loavo ioom foi
28
1his is nol lho caso unooi a foiwaio looking iulo, sinco lhoio, ovon in a slanoaio full-
pailicipalion oconomy loo sliong a iosponso loaos lo inooloiminacy - soo Loinako ano Woofoio
1007.
sunspol-oiivon ioal luclualions. 1ho sizo of lhoso luclualions woulo oopono upon
lho sizo of lho sunspol shocks (somolhing impossiLlo lo quanlify in piaclico), Lul
lhis woulo unamLiguously incioaso lho vaiiancos of ioal vaiiaLlos such as oulpul ano
inlalion. If such vaiianco is wolfaio-oamaging, il is cloai lhal such policios woulo
Lo suLoplimal sinco sunspol luclualions lhomsolvos woulo Lo wolfaio-iooucing. In
conliasl, in lho samo `non-Koynosian oconomy`, a passivo iulo woulo iulo oul such
luclualions ano woulo Lo closoi lo oplimal policy. Lul woll Loyono iuling oul
sunspol luclualions, lho piosonco of limiloo assol maikols pailicipalion is likoly
lo mooify lho oplimal iosponso lo funoamonlal shocks loo. Oui noxl lask is lo
chaiacloiizo oplimal policy iulos in lho piosonco of non-assol holoois.
1ho oLjoclivo funclion is calculaloo as follows. Following Wooofoio (2008)
wo uso a socono-oiooi appioximalion lo a convox comLinalion of housoholos` ulil-
ilios, oosciiLoo in oolail in Apponoix D. Wo mako a soiios of assumplions lhal
allow us lo uso lhis socono-oiooi appioximalion lochniquos. Fiislly, wo assumo
lhal omcioncy of lho sloaoy slalo is oLlainoo Ly appiopiialo lscal insliumonls
inoucing maiginal cosl piicing in sloaoy slalo (suLsioios foi salos al a ialo oqual
lo lho sloao-slalo nol maik-up lnancoo Ly lump-sum laxos on lims). Sinco lhis
policy makos sloaoy-slalo pioll incomo zoio, lho sloaoy-slalo is also j&.nh|:
sloaoy-slalo consumplion shaios of lho lwo agonls aio oqual, making aggioga-
lion much simploi. 1his onsuios consisloncy wilh lho moool oullinoo aLovo
20
.
Soconoly, wo assumo lhal lho social plannoi maximizos a convox comLinalion
of lho ulililios of lho lwo lypos, woighloo Ly lho mass of agonls of oach lypo:
l
|
(.) = `l
1
(C
1,|
,
1,|
) [1 `[ l
S
(C
S,|
,
S,|
). Wo will assumo lhal lho con-
lial Lank maximizos lho fuluio oiscounloo valuo of lhis oLjoclivo funclion. 1his
is consislonl wilh oui viow lhal limiloo pailicipalion lo assol maikols comos fiom
n:n.n ano nol piofoioncos, sinco in lho lalloi caso maximizing inloilompoially
lho ulilily of non-assol holoois woulo Lo haio lo juslify on wolfaio giounos. How-
ovoi, nolo lhal foi lho oisciolionaiy Maikov oquiliLiium sluoioo hoio, lhis choico
makos no oiloionco sinco loims fiom limo t 1 onwaios aio lioaloo paiamoliically
in lho maximizalion ano lho limo-t oLjoclivo funclion is ioonlical. 1ho following
Iioposilion shows how lho oLjoclivo funclion can Lo iopiosonloo (up lo socono
oiooi) as a oiscounloo sum of squaioo oulpul gap ano inlalion (lho pioof is in
Apponoix D).
Inoioi1io: 8. 1J h nJj n J h nJ| .n 5.n . c_c1cuI h
njj:jn &|Jn: J&n.n nn h n:r.nnJ hj ;.jn:.nj :n .nJnJn J
|.j nnJ :n J :J: h.jh: hnn .):
|
=
l
c
C
2
-
c
1
|
I=|
_
cr
2
|I

2
|I
_
, (6.1)
c =
,
1 `
[1 `(1 ) (1 ,)[
c
-
.
Nolo lhal whon ` = 0 wo aio Lack lo lho slanoaio caso c = (, )
r
:
. In lho
caso sluoioo oxlonsivoly in lho iosl of lhis papoi ( = 1), lho iolalivo woighl on
oulpul gap is c =
l,
lX
r
:
ano is incioasing in lho shaio of non-assol holoois. In
20
Nolo, howovoi, lhal sinco sloaoy-slalo consumplion shaios aio oqual wo oo nol nooo lo
assumo incioasing ioluins. Unooi lhoso assumplions, lho iooucoo-foim coomcionls simply mooily
as follows:
o
= 1 , ano c
o
= 1 ,A (1 A) .
gonoial, an incioaso in lho shaio of non-assol holoois loaos lo an incioaso in lho
iolalivo woighl on oulpul (if _
,
l,
, which is ompiiically plausiLlo)
80
. Whon `
lonos lo ono, lho implicil iolalivo woighl on oulpul slaLilizalion lonos lo inlnily
(foi , 0). Honco, lho piosonco of non-assol holoois mooilos lho liaoo-ol facoo
Ly lho monolaiy aulhoiily. 1ho inluilion foi lhis iosull is simplo. Sinco aggiogalo
ioal piolls can Lo wiillon as 1
|
= [1 ('C
|
,1
|
) ^
|
[ 1
|
, iolalivo piico oispoision
^
|
(iolaloo hoio linoaily lo squaioo inlalion) oiooos aggiogalo pioll incomo foi
givon lovols of oulpul ano maiginal cosl. Givon lhal only a fiaclion of (1 `)
iocoivos pioll incomo, whon lhis fiaclion falls lho wolfaio-Lasoo iolalivo woighl on
inlalion (piico oispoision) also falls. Inlalion Locomos complololy iiiolovanl foi
wolfaio puiposos whon ` 1: sinco noLooy holos assols, assol incomo nooo nol Lo
slaLilizoo.
1ho oplimal oisciolionaiy iulo r
o
|
0
is founo Ly minimizing
|
laking as
a consliainl lho syslom givon Ly (4.8) ano (4.2) ano io-oplimizing ovoiy poiioo
81
.
Nolo lhal Ly usual aigumonls lhis oquiliLiium will Lo limo-consislonl. 1his is,
up lo inloipiolalion of lho solulion, isomoiphic lo lho slanoaio pioLlom in CGG
(1000). Honco, foi Liovily, wo skip solulion oolails availaLlo olsowhoio ano go lo
lho iosull:
(6.2) r
|
=
i
c
|
=
-
O

|
Whon inlalion incioasos (oocioasos) lho conlial Lank has lo acl in oiooi lo conliacl
(oxpano) oomano. Assuming an AI(1) piocoss foi lho cosl-push shock 1
|
n
|l
=
j
u
n
|
foi simplicily, wo oLlain lho following iooucoo foims foi inlalion ano oulpul
fiom lho aggiogalo supply cuivo:
|
= c
1
i
2
c(1 ,j
u
)
n
|
(6.8)
r
|
= i
1
i
2
c(1 ,j
u
)
n
|
Sinco c is gonoially incioasing in `, in an oconomy wilh limiloo assol maikol pai-
licipalion oplimal policy iosulls in gioaloi inlalion volalilily ano lowoi oulpul gap
volalilily lhan in a full pailicipalion oconomy (` 0). Oplimal policy in lhis
caso ioquiios moio oulpul slaLilizalion al lho cosl of accommooaling inlalionaiy
piossuios.
SuLsliluling lho oxpiossions givon Ly (6.8) inlo lho IS cuivo, wo oLlain lho
.n|.. .n:&nn :&| consislonl wilh oplimalily
82
:
r
o
|
= r
|
c
o
t
1
|
|l
, (6.4)
c
o
t
=
_
1
ci
c
1 j
u
j
u
_
.
Somo of lho iosulls oLlainoo in a full-pailicipalion oconomy caiiy ovoi: fiom lho
oxislonco of a liaoo-ol Lolwoon inlalion ano oulpul slaLilizalion, lo convoigonco
80
Whon lhis conoilion is nol fulllloo, so < , (1 ,) , lho iolalivo woighl on oulpul gap
is oocioasing in A ano can ovon Locomo nogalivo whon A [(1 ) (1 ,)[
. Wo oxcluoo lhis
paiamoloi iogion on giounos of ils Loing ompiiically iiiolovanl.
81
1o koop lhings simplo, wo focus on lho oisciolionaiy, ano nol fully oplimal (commilmonl)
solulion lo lho conlial Lankoi`s pioLlom. 1his caso can Lo aiguoo lo Lo moio ioalislic in piaclico,
as oo CGG (1000).
82
A posilivo policy iosponso lo inlalion ioquiios c ci
p
r
p
r
.
of inlalion lo ils laigol unooi lho oplimal policy (o.g. CGG (1000) ). Also, ioal
oisluiLancos alocl nominal ialos only insofai as lhoy alocl lho Wicksollian inloiosl
ialo, as oiscussoo foi oxamplo Ly Wooofoio (2008 p.20). 1hoio is ono impoilanl
oxcoplion howovoi, omphasizoo in lho following Iioposilion.
Inoioi1io: 4. 1n n nn-1jn.nn nnj ;c < 0) h .n|.J .n:&nn
:&| J: .nn| |.j . n. c
o
t
< 1. Jh .nn| :n .nn.n .
J:n.nj .n h hn: J nn-n h|J:
J
c
JX
< 0 nnJ hnnj J:n n.
n. n c hnnj .jn.
1ho aLovo Iioposilion shows lho oxacl way in which lho conlial Lank has lo
chango ils insliumonl in oiooi lo mool lho laigoling iulo (6.2): conliacl oomano
whon inlalion incioasos, Lul movo nominal ialos such lhal lho ioal ialo J:n
whon c is nogalivo. 1his happons Locauso, as oxplainoo pioviously, ioal inloiosl
ialo culs aio associaloo wilh a fall in cuiionl aggiogalo oomano whon lho slopo of
lho IS cuivo is posilivo (c < 0).
Finally, whon cosl-push shocks aio aLsonl (ano lhoio is no inlalion-oulpul
slaLilizalion liaoo-ol), lho loxiLlo-piico allocalion can Lo achiovoo Ly having lho
nominal ialo oqual lho Wicksollian ialo al all limos r
o
|
= r
|
, as in lho slanoaio
moool (o.g. Wooofoio, Ch. 4). Howovoi, nolo an impoilanl oiloionco wilh iospocl
lo lho Lasolino moool: whon c < 0 lhis policy can also Lo consislonl wilh a uniquo
ialional oxpoclalions oquiliLiium
88
. 1o soo lhis nolo lhal such a policy is oquivalonl
fiom an oquiliLiium-ooloiminacy slanopoinl lo an inloiosl ialo pog, i.o. an inloiosl
ialo iulo wilh c
t
= 0. Fiom Iioposilion 1, ono can oasily soo lhal such a policy
iulo loaos lo oquiliLiium ooloiminacy if 1 c
2(lo)
r
_ 0
84
.Howovoi, lho aLilily of
lho conlial Lank lo achiovo full piico slaLilily as lho &n.j& oquiliLiium applios
lo lho simplo moool assumoo hoio ano iolios upon lho aLililywillingnoss of lho
Lank lo moniloi lho naluial ialo of inloiosl ano malch ils movomonl ono-lo-ono Ly
movomonls in lho nominal ialo. Moioovoi, lho naluial inloiosl ialo can somolimos
Lo nogalivo. All lhoso cavoals suggosl lhal lhis iosull is unlikoly lo havo much
piaclical iolovanco.
7. TLe eects oI sLocks and cycIIcaI InIIcatIons
In lhis soclion wo go Lack lo lho simplo insliumonl iulo ano compulo an-
alylically lho olocls of funoamonlal ano sunspol shocks unooi ooloiminacy ano
inooloiminacy, allowing foi lho chango in sign of c ouo lo LAMI. Oui inloiosl in
lhis oxoiciso is lwofolo. Fiisl, il mighl Lo of inloiosl in ilsolf lo unooislano lho
olocls of shocks in a J:n.nn non-Koynosian oconomy. Ono oLvious hisloiical
canoioalo foi such a caso is lho pio-Volckoi poiioo; il is faiily woll oslaLlishoo (soo
o.g. CGG (2000), 1ayloi (1000), LuLik ano Schoifhoioo (2004)) lhal lho iosponso
of monolaiy policy in lhal poiioo implioo a (long-iun) iosponso lo inlalion of loss
lhan ono. Lul if wo allow foi lho possiLilily lhal pailicipalion lo assol maikols
was so limiloo lhal c < 0, lhis woulo not imply lhal policy was inconsislonl wilh
a uniquo oquiliLiium. Honco, wo will Lo aLlo lo assoss lho olocls of funoamonlal
88
In lho Lasolino moool, lho Lank nooos lo commil lo iospono lo inlalion Ly fulllling lho
1ayloi piinciplo v
o
I
= v
I

r
I,
r
1 in oiooi lo pin oown a uniquo oquiliLiium.
84
In loims of ooop paiamolois, lhis conoilion lianslalos inlo A
1

T
`
,
0c0
0c0
.
shocks, an impossiLlo lask unooi inooloiminacy. Inoooo, in a companion papoi (Lil-
Liio (2004)) wo aiguo lhal lhis was lho caso, ano funoamonlal shocks can oxplain
slylizoo facls of lho pio-Volckoi poiioo (impulso iosponsos lo shocks ano momonls)
quilo woll. Soconoly, lhoio is lho miiioi imago of lho aLovo aigumonl. Lslimalos
of policy iulo coomcionls in lho Volckoi-Gioonspan oia foi lho US ano olhoi inous-
liializoo counliios inoicalo a iosponso of nominal ialos lo inlalion laigoi lhan ono
(soo o.g. CGG (2000) ). Couploo wilh lho possiLilily of a non-Koynosian oconomy
(c < 0), lhis woulo insloao imply inooloiminacy. Honco, il mighl Lo of inloiosl lo
assoss lho olocls of vaiious (funoamonlal ano sunspol) shocks in an inooloiminalo
oquiliLiium. 1his mighl Lo iolovanl foi counliios wilh unooioovolopoo lnancial
maikols lhal novoilholoss puisuo an aclivo policy.
Wo follow lho now molhoo pioposoo Ly LuLik ano Schoifhoioo (2008) lo com-
pulo sunspol oquiliLiia Ly oocomposing oxpoclalion oiiois. 1ho (4.2)-(4.8) syslom
can Lo wiillon, in loims of nowly oolnoo vaiiaLlos (foi / = r, )
|
|
= 1
|
/
|l
ano
oxpoclalion oiiois j
|
|
= /
|
1
|l
/
|
:
|
=
|l
i
|
j
|
whoio
|
= (
r
|
,
t
|
)
ano j
|
= (j
r
|
, j
t
|
)
. 1ho coomcionl maliicos , aio slill lho

samo givon in (.2). Wo ioplaco Ly ils Joioan oocomposilion = JQJ
l
, oolno
lho auxiliaiy vaiiaLlos .
|
= J
l
|
ano iowiilo lho aLovo moool as
(7.1) .
|
= Q.
|l
J
l
w-
|
J
l
Ij
|
1ho oigonvaluos of aio:
=
1
2
_
trI
_
(trI)
2
4 ool I
_
,
(whoio lho ooloiminanl ano liaco aio ool = ,
l
1, tr=1,
l
,
l
c
l
i(c
t
1)).
1ho coiiosponoing oigonvoclois aio slackoo in lho J maliix:
J =
_
l
r
(1 ,
)
l
r
(1 ,
)
1 1
_
7.1. DeternInacy. 1ho oquiliLiium unooi ooloiminacy is pailiculaily oasy
lo calculalo whon shocks havo zoio poisislonco, sinco lho only slaLlo solulion is
|
= 0, oLlainoo foi:
i
|
j
|
= 0
Honco, lho oxpoclalion oiiois aio ooloiminoo oxclusivoly Ly funoamonlal shocks
(ano sunspol shocks woulo havo no olocl on oynamics) Ly j
|
=
l
i
|
, namoly:
(7.2) j
|
= c
l
_
1
i
_
(-
|
r
|
)
_
0
1
_
n
|
1ho inilial impacl on oulpul ano inlalion is also givon Ly lho samo oxpiossion.
Sinco Lolh iools aio oliminaloo unooi ooloiminacy, lhoio is no poisislonco. Nolo
lho shaip oiloioncos foi lho lwo suL-casos ioonliloo aLovo, showing asymmoliic
olocls of somo shocks ooponoing on lho sign of c.
Case I: c 0, c
t

_
1, 1 c
2(lo)
r
_
: 1ho olocls al woik aio of lho usual
sign, Lul of oiloionl magniluoo. A policy-inoucoo inloiosl ialo cul oi an incioaso
in lho naluial ialo of inloiosl (coming hoio only fiom shocks lo lochnology giowlh)
incioaso Lolh lho oulpul gap ano inlalion. 1hoso olocls aio sliongoi, lho highoi
lho shaio of non-assol holoois (ano lho highoi c
l
). Ono-limo cosl-push shocks havo
no olocl on lho oulpul gap, ano incioaso inlalion ono-lo-ono; lhis is only Locauso
lho inloiosl ialo iulo iosponos lo oxpocloo fuluio inlalion, whoioas a ono-limo
shock incioasos only inlalion looay.
Case II: uou-1cucs1uu ccouon, c < 0, c
t

_
1 c
2(lo)
r
, 1
_
. In con-
liasl lo lho slanoaio caso, a monolaiy conliaclion (posilivo -
|
) has oxpansionaiy
olocls, ano causos inlalion. 1his follows oiioclly Ly lho mochanism oiscussoo in
oolail aLovo. An incioaso in lho naluial ialo of inloiosl oiivon Ly lochnology io-
sulls in a iocossion ano oolalion. Il is cloai lhon lhal a policy iosponso incioasing
lho nominal ialo Ly moio lhan lho naluial ialo -
|
r
|
incioasos Lolh oulpul ano
inlalion, whoioas whon il falls shoil of ooing so, il has oolalionaiy olocls, ano
causos a fall in oulpul. 1hoso olocls oiminish as ` lonos lo 1, sinco c
l
lonos lo
zoio. Cosl-push shocks havo lho samo olocls iogaioloss of lho sign of c ouo lo lho
zoio-poisislonco assumplion. Howovoi, in lho piosonco of poisislonco lho nnjn.&J
of lho iosponsos lo lhoso shocks will oopono on c, sinco in lhal caso lho iools of
lho syslom malloi foi oynamics (soo LilLiio (2004) foi somo simulalions).
CycIIcaI InIIcatIons.
Whilo ovioonco ovoiwholmingly suggosls lhal piolls aio piocyclical (soo Iolom-
Loig ano Wooofoio (1000)), lho mochanism unooilying oui iosulls mighl soom lo
ioly on counloicyclical piolls. In lhis suLsoclion wo Liioly show lhal lhis is nol
nocossaiily lho caso. Fiisl, nolo lhal lho conoilion foi piolls lo Lo piocyclical
dd,dj 0 is (soo Apponoix): dr <
(lJ
`
)Ju
_(lJ` )(lJ` )Ju
dj
, whoio wo oioppoo
limo suLsciipls, ano lho iighl-hano sioo loim is oxogonous ano ooponos on loch-
nology. Whon shocks havo zoio poisislonco, wo know lho solulion foi oulpul gap
fiom (7.2) as: dr = c
l
d (- r
) <
(lJ
`
)Ju
_(lJ` )(lJ` )Ju
dj
. Wilhoul a cosl-push
shock, lhis conoilion Locomos c
l
d (- r
) < [j, ((1 1

Y
) j)[ dj
. Wo can
honco soo an oxamplo whoioLy c
l
< 0 salislos lhis conoilion ano loaos lo piocycli-
cal piolls. Namoly, if lho shock lo lochnology is such lhal dj
0, Lul lho policy

iosponso is such lhal d- < dr
piolls aio always piocyclical in lho non-Koynosian

oconomy, ano counloicyclical olhoiwiso. Alloinalivoly, lho samo is liuo if lhoio is
no shock lo lochnology (dj
= 0) ano d- < 0.
Moioovoi, wo can assoss how iolalivo pioll cyclicalily ooponos on lho oogioo
of assol maikol pailicipalion
8
. Wo lako lwo oconomios wilh oiloionl pailicipalion
ialos ano ask unooi whal conoilions ooos ono havo moio piocyclical piolls lhan
lho olhoi (lako lho caso whoio 1
Y
= j sinco is inooponoonl on ` ano so j
is
also inooponoonl of `), namoly:
JJ
J

JJ
=
Jnc
J
<
Jnc
=
J
J

J
= dr < dr
0
. Foi lho zoio-poisislonco
caso again lhis Locomos: c
l
d (- r
) c
l
0
d (- r
) . Honco, if d (- r
) 0,
lho conoilion foi dd,dj dd
0
,dj
0
is c
l
c
l
0
. 1his moans lhal in caso lho shocks
conlguialion is such lhal lho policy iosponso oxcooos lho naluial ialo, a Koynosian
oconomy has moio piocyclical piolls lho highoi ils ` (c
l
is incioasing in `). A non-
Koynosian oconomy c
l
< 0 has always loss piocyclical piolls lhan a Koynosian
ono (Lul golling moio ano moio piocyclical as ` incioasos). Howovoi, whon lho
8
1his is ospocially impoilanl, sinco an oconomy wilh limiloo pailicipalion can imply n:
piocyclical piolls lhan an oconomy wilh full pailicipalion wilhoul nocossaiily implying piocyclical
piolls. 1hal is Locauso in a slanoaio slicky-piico moool piolls can Lo sliongly counloi-cyclical,
unloss ono inliooucos laLoi hoaioing, vaiiaLlo ulilizalion, oi olhoi foaluios moanl lo Lioak lho
link Lolwoon maikup ano piolls (soo IolomLoig ano Wooofoio 1000).
policy iosponso falls shoil of lho naluial ialo, lho opposilo holos: c
l
< c
l
0
.
A non-Koynosian oconomy will honco always havo moio piocyclical piolls lhan
a Koynosian ono. Finally, nolo lhal if lho souico of luclualions is only a cosl-
push shock lho conoilion is
Ju
J
<
Ju
J
so dj dj
0
. 1his can oasily Lo lho caso
whon lho shock poisislonco is oiloionl lhan zoio (nolo lhal wilh zoio poisislonco
lho iosponso of oulpul is zoio). Foi inslanco, unooi lho oplimal policy solulion
calculaloo in (6.8), lho iosponso of oulpul lo a cosl shock is always laigoi (loss
nogalivo) whon ` is laigoi; lhis implios lhal piolls aio moio piocyclical lho laigoi
is `.Similai ioasoning applios lo lho cyclicalily of ioal wago, noling lhal moio
piocyclical piolls imply loss piocyclical ioal wago.
7.2. IndeternInacy. In lhis caso ono of lho iools
will Lo insioo lho unil

ciiclo. Sunspol shocks havo ioal olocls, ano lho iosponsos lo funoamonlal shocks
chango loo in a way maoo oxplicil Lolow. Wo conlno ouisolvos lo lho caso whoioLy
lho smalloi iool is insioo lho unil ciiclo ano lho laigoi ono is gioaloi lhan ono, i.o.
(1, 1) ano
1. 1his can Lo shown lo Lo lho caso if oilhoi (i) c 0, c

t
< 1
oi (ii) c < 0, c
t
1
86
. Sinco in lhis caso lhoio is ono-oimonsional inooloiminacy,
lho slaLilily conoilion foi (7.1) mooilos: oxpoclalion oiiois aio nol spannoo Ly
funoamonlal shocks, Lul Ly Lolh funoamonlal ano sunspol shocks.
Wo can apply lho iosulls in Iioposilion 1 in LuLik ano Schoifhoioo (2008) lo
solvo foi lho full solulion sol foi lho oxpoclalion oiiois. 1his is oosciiLoo in somo
oolail in lho Apponoix, ano lho solulion is:
j
|
=
ic
l
d
2
_
i
_
(-
|
r
|
)
1
d
2
_
i,
l
(1
)
(1
)
_
,
l
_
_
n
|

1
d
_

1
i
_
('
l
i
|

|
) , (7.8)
whoio '
l
is an aiLiliaiy 22 maliix ano
|
is a iooucoo-foim sunspol shock,
which can Lo inloipioloo as a Loliof-inoucoo incioaso in oulpul anooi inlalion
of unooloiminoo sizo. Fiisl lhing lo nolo is lhal a posilivo ioalizalion of lhis
shock will incioaso oulpul ano inlalion no malloi wholhoi c 0 sinco
1 as
oslaLlishoo aLovo. 1his confoims oui inluilivo consliuclion of sunspol oquiliLiia
whon oiscussing ooloiminacy piopoilios of inloiosl-ialo iulos.
On lho olhoi hano, lho olocls of funoamonlal shocks Locomo amLiguous, ano
oopono ciucially upon lho choico of lho '
l
maliix.Unfoilunaloly, lhoio is nolh-
ing lo pin oown a choico foi lhis maliix, which capluios a woll-known pioLlom
of inooloiminalo oquiliLiia - lho olocls of funoamonlal shocks cannol Lo sluoioo
wilhoul fuilhoi iosliiclions. 1wo loaoing possiLililios lo iosliicl lho '
l
maliix aio
suggosloo Ly LuLik ano Schoifhoioo.
7.2.1. O:hjnn|.j. 1ho lwo sols of shocks aio oilhogonal in lhoii conliiLu-
lion lo lho foiocasl oiioi, ano honco '
l
= 0 in (7.8). 1ho olocl of a cosl-push
shock is of lho samo sign unooi oilhoi sconaiio, as is inooponoonl of c. A posilivo
ioalizalion of lhis shock woulo incioaso inlalion (sinco (1
)
_
,
l
_
0)
ano oocioaso oulpul (
1). 1ho olocls of policy shocks, ano of shocks lo lho

naluial ialo of inloiosl, aio again oiloionl ooponoing on which caso wo consiooi:
86
Foi lho iosl of lho paiamoloi iogions whoio lhoio is inooloiminacy wo woulo havo q
(1, 1) ano q < 1, Lul lhis can Lo shown lo imply voiy iosliiclivo conoilions on lho ooop
paiamolois ano lho policy iulo coomcionl.
I. Slanoaio caso, c 0: An inloiosl ialo incioaso kooping conslanl lho naluial
ialo oocioasos oulpul unooi ils naluial lovol Lul causos inlalion as 1
< 0 (lhis
is also founo Ly LuLik ano Schoifhoioo foi a conlompoianoous iulo). An incioaso in
lho naluial ialo wilhoul a oisciolionaiy policy iosponso incioasos lho oulpul gap
ano causos oolalion.
II. `Non-Koynosian oconomy` c < 0: A policy-inoucoo inloiosl ialo incioaso
incioasos oulpul ano causos oolalion. An incioaso in lho naluial ialo nol malchoo
Ly policy oopiossos oulpul ano causos inlalion. In oilhoi caso, lho ovoiall olocl on
inlalion ano lho oulpul gap ooponos on wholhoi lho policy iosponso is sliongoi oi
woakoi lhan lho vaiialion in lho naluial ialo.
7.2.2. n.n&.j. In oiooi lo piosoivo conlinuily of lho impulso iosponsos lo
lho funoamonlal shock whon passing fiom ooloiminacy lo inooloiminacy, '
l
can
Lo choson such lhal il implios lhal lho iosponso lo lho funoamonlal shock is lho
samo, i.o.:
j
|
= c
l
_
1
i
_
(-
|
r
|
)
_
0
1
_
n
|

1
d
_

1
i
|
1his happons foi a voiy pailiculai '
l
maliix ano implios lhal lho olocls of funoa-
monlal shocks aio as unooi ooloiminacy, namoly in lho `non-Koynosian oconomy`
caso a conliaclionaiy policy shock incioasos Lolh oulpul ano inlalion. Whilo con-
linuily is an alliaclivo foaluio, lhoio is nolhing lo insuio lhal lho '
l
lakos oxaclly
lho foim nocossaiy lo gol lhis iosull.
8. DIstortIonary redIstrILutIve taxatIon restores KeynesIan IogIc.
1ho mochanism of lho piovious iosulls iolios on incomo olocls on laLoi supply
fiom lho ioluin on shaios. 1his hinls lo an oLvious way lo iosloio Koynosian
logic iolying on a spocilc lscal policy iulo: lax oivioono incomo ano oisliiLulo
piocoooings as liansfois lo non-assol holoois. Wo focus on lho non-Koynosian
caso whoioLy in lho aLsonco of lscal policy c < 0. 1o mako lhis poinl, consiooi
lho following simpliloo lscal iulo: piolls aio laxoo al ialo t
|
ano lho Luogol is
Lalancoo poiioo-Ly-poiioo, wilh lolal lax incomo t
|
1
|
Loing oisliiLuloo lump-sum
lo all non-assol holoois. Wo focus on lho caso whoio piolls aio zoio in sloaoy-slalo.
1ho Lalancoo-Luogol iulo lhon is t
|
1
|
= `1
1,|
which in log-linoaiizoo foim (Lolh
piolls ano liansfois aio shaios of sloaoy-slalo GDI) is: `|
1,|
= td
|
. Ioplacing
lhis inlo lho now Luogol consliainl of non-assol holoois wo gol c
1,|
= n
|

r
X
d
|
.
Assol holoois` consumplion will lhon Lo givon Ly (suLsliluling lho oxpiossion foi
piolls): c
S,|
= (1 `)
l
[1 tj, (1 j)[ j
|
(t `) , (1 `) n
|
. Solling shocks
lo zoio foi simplicily, lho wago-houis locus is lhon oLlainoo following lho samo
molhoo as Lofoio: n
|
= (1 t)
l
[1 , j(1 t)[ :
|
. Finally, consumplion of
assol holoois as a funclion of lolal oulpul is:
c
S,|
= c
r
j
|
, whoio c
r
=
1
1 t
_
1 t
j
1 j

t `
1 `
,
1 j
_
Foi a givon ` lhoio oxisls a minimum lhiosholo foi lho lax ialo such lhal
c
r
0 whon in lho aLsonco of such lscal policy c < 0. 1his lhiosholo is (nolo lhal
,, (1 `) j 0 whoio c < 0):
t 1
1 ,
l
lX
, j
< 1
1ho nocossaiy lax ialo is highoi, lho moio inolaslic is laLoi supply ano lho
highoi lho shaio of agonls wilh no assols. 1ho inluilion foi lhis iosull is sliaighl-
foiwaio: a highoi lax ialo on assol incomo oliminalos somo of lho incomo olocl of
oivioono vaiialion on assol holoois` laLoi supply.
9. ConcIusIons
Inloiosl ialo changos mooify lho inloilompoial consumplion ano laLoi supply
piollo of n h|J:, agonls who smoolh consumplion Ly liaoing in assol maikols.
1his alocls lho ioal wago, ano lho oomano lhoioLy of agonls who havo no assol
holoings, aio ovoisonsilivo lo ioal wago changos, ano insonsilivo oiioclly lo inloiosl
ialo changos. Vaiialions in lho ioal wago (maiginal cosl) loao lo vaiialions in
piolls ano honco in lho oivioono incomo of assol holoois. 1hoso vaiialions can
oilhoi ioinfoico (if pailicipalion is nol `loo` limiloo) oi :&:n lho inilial impacl
of inloiosl ialos on aggiogalo oomano. 1ho lalloi caso occuis if lho shaio of non-
assol holoois is high onough anooi ano lho olaslicily of laLoi supply is low onough,
foi lho polonlial vaiialions in pioll incomo olsol lho inloiosl ialo olocls on lho
oomano of assol holoois. 1his is lho main mochanism ioonliloo Ly lhis papoi lo
chango oiamalically lho olocls of monolaiy policy as compaioo lo a slanoaio full-
pailicipalion caso whoioLy aggiogalo oomano is complololy oiivon Ly assol holoois.
1ho ioquiioo shaio of non-assol holoois foi lhoso iosulls lo holo is iolalivoly milo
compaioo lo ompiiical oslimalos of CampLoll ano Mankiw (1080) oi oiiocl oala on
assol holoing (soo Mulligan ano Sala-i-Mailin (2000) ano Vissing-Joigonson (2002)).
1his papoi oovolops an analylical fiamowoik (Luiloing on lho oxisling liloia-
luio) ano usos il lo sluoy in oolail lho monolaiy policy implicalions of lho foiogoing
insighl. Oui iosulls havo cloai noimalivo implicalions. In a nulsholl, conlial Lank
policy shoulo Lo puisuoo wilh an oyo lo lho aggiogalo oomano sioo of lho oconomy:
lho oxlonl lo which agonls pailicipalo il assol maikols woulo Locomo an impoilanl
pail of lho policy inpul. Whilo lho oogioo of oovolopmonl of lnancial maikols
may woll mako lhis nol a concoin in piosonl limos in lho oovolopoo oconomios,
conlial Lanks in oovoloping counliios wilh low pailicipalion in lnancial maikols
mighl lno lhis of piaclical inloiosl. 1ho lhooiolical iosulls hinling lo such policy
piosciiplions aio lhal limiloo pailicipalion Loyono a coilain lhiosholo makos lho
oconomy Lohavo in a `non-Koynosian` way. Namoly, lho IS cuivo changos sign, ano
an Ìnvoiloo 1ayloi Iiinciplo` applios
87
: lho conlial Lank nooos lo aoopl a passivo
policy iulo lo onsuio oquiliLiium uniquonoss ano iulo oul lho possiLilily of solf-
fulllling, sunspol-oiivon luclualions. Moioovoi, oplimal limo-consislonl monolaiy
policy also ioquiios lhal lho conlial Lank movo nominal ialos such lhal ioal ialos
ooclino (lhoioLy conlaining aggiogalo oomano). 1ho olocls ano liansmission of
shocks aio also oiamalically mooiloo.
1ho mooosl scopo of lhis sluoy is lo mako a conliiLulion lo lho liloialuio om-
phasizing lho iolo of LAMI in shaping maciooconomic policy ano holping lowaios
87
1his iosull ooponos only lo a small oxlonl on wholhoi lho iulo is spociloo in loims of
cuiionl oi oxpocloo fuluio inlalion. As oiscussoo in loxl in moio oolail, lhis is in conliasl lo
Gali, Lopoz-Salioo ano Vallos (2008) who, whilo having noloo lho possiLilily lo violalo lho 1ayloi
piinciplo foi a foiwaio-looking iulo, also aiguo lhal a slionglhoning of lho 1ayloi piinciplo is
ioquiioo foi a conlompoianoous iulo lo iosull in oquiliLiium uniquonoss. A voiy sliong iosponso
lo cuiionl inlalion woulo also insuio ooloiminacy in oui moool, Lul wo lno lho implioo coomcionl
is highoi lhan any plausiLlo oslimalos, makos policy non-ciooiLlo ano qoulo loao lo violalion of
lho zoio lowoi Louno in caso of small oolalions.
a Lolloi unooislanoing of lho oconomy. In lhal iospocl, wo jusl sook lo aoo lo a
now oovoloping liloialuio analyzing lho iolo of non-assol holoois in maciooconomic
oynamic gonoial oquiliLiium moools (soo Mankiw (2000), Gal, Lopoz-Salioo ano
Vallos (2002) oi Alvaioz, Lucas ano WoLoi (2001)). Oui moool has lho aovanlago
of simplicily: wo sluoioo oconomios wilh limiloo assol maikols pailicipalion analyl-
ically in lho samo lypo of fiamowoik usoo in slanoaio, full-pailicipalion analysos.
1his simplicily (shaioo wilh lho iosl of lho liloialuio), whilo jusliloo on liaclaLilily
giounos, can polonlially also Lo a shoilcoming foi il implios many ioalislic foaluios
havo Loon lofl oul. Il is impoilanl in oui viow lo moool lho oocision lo pailicipalo
in assol maikols oxplicilly, allowing foi housoholo holoiogonoily ano an onoogonous
shaio of assol holoois. Laslly, an ompiiical assossmonl of limiloo pailicipalion, ils
oynamics ano implicalions al lho maciooconomic aggiogalo lovol, is in oui viow a
nocossaiy slop foi unooislanoing Lusinoss cyclos, which wo puisuo in cuiionl woik.
HeIerences
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1ayloi, J. ano Wooofoio, M. oos, `HanoLook of Maciooconomics, Volumo 1L, Noilh-Hollano.
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nomic Dynamics, Vol. 8 (8) pp. 28-0
[4[ Loinako, L. ano Wooofoio, M. 1007 Ìnlalion foiocasls ano monolaiy policy`, Jouinal of
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Domano: Foo policy was Lolloi lhan wo lhink.`, LCL Woiking Iapoi 408.
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Ioviow 01(2): 282-287
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[4[ Zoloos, S. 1080 Consumplion ano Liquioily Consliainls: an Lmpiiical Invosligalion", Joui-
nal of Iolilical Lconomy 07(2), 80-46
AendIx A. LInIted artIcIatIon due to transactIon costs: an
exanIe.
1ho puiposo of lhis Apponoix is lo show lhal oui assumplion on limiloo pailic-
ipalion in assol maikols can Lo suppoiloo Ly lho piosonco of holoiogonous liansac-
lion cosls. Oui moool oiaws on a laigo liloialuio on assol-piicing wilh liansaclion
cosls, ano ils puiposo is moioly lo show how foi a givon lovol of lho non-pailicipalion
A-2 FLOIIN O. LILLIIL
ialo `, lhoio oxisls a sliucluio of cosls lhal suppoils il. Such cosls havo Loon
omphasizoo Ly many as ono impoilanl oxplanalion foi lho oLsoivoo pailicipalion
sliucluios (soo Vissing-Joigonson [2008[ ano Iaiolla [2004[ foi ompiiical oslimalos).
1his liloialuio oiiginalos wilh Cochiano [1080[ , who showoo lhal lho foiogono ulil-
ily gains fiom consuming ono`s incomo as opposoo lo following a poimanonl-incomo
oocision iulo aio likoly lo Lo voiy small (10 conls lo 1 oollai poi quailoi); conso-
quonlly, lho lowoi Louno on liansaclion cosls piovonling an agonl fiom following a
poimanonl-incomo iulo (o.g. pailicipaling in assol maikols) is likoly lo Lo small. Ho
ano Mooosl [100[ sluoy lho iolo of maikol fiiclions, incluoing piopoilional lians-
aclion cosls, in ioconciling assol maikol oquiliLiium wilh oala on consumplion ano
assol ioluins. Using oala fiom lho Suivoy of Consumoi Financos, Mulligan ano
Sala-i-Mailin (2002) oslimalo lhal lho mooian poi-poiioo liansaclion cosl foi nnj
.n:-hn:.nj n is 111 oollais poi yoai.
Supposo lhal oach limo lho housoholo goos lo lho assol maikol il has lo pay
a piopoilional liansaclion cosl which is housoholo-spocilc /
. 1ho oplimalily con-

oilion unooi piopoilional liansaclion cosls is (whoio lho socono inoqualily holos
foi silualion in which lho housoholo solls lho assol shoil, i.o. Liings consumplion
foiwaio - soo also Ho ano Mooosl):
_
1 /
_
1
|
_
A
|,|l
1
o
|l
_
1
(1 /
)
whoio A
|,|l
= ,1
|
l
c
(C
,|l
) , [l
c
(C
,|
) 1
|l
[ is lho slochaslic oiscounl facloi of
housoholo , ano 1
o
|l
is lho oxpocloo gioss ioluin of assol a. Supposo foi simplicily
lhal lhoio aio lwo lypos of agonls: ono lypo inooxoo Ly o facos no liansaclion cosls
/
S
= 0 whilo lho olhoi inooxoo Ly H has lo pay a piopoilional cosl /
1
= / foi
oach liansaclion. Such an oxliomo, Limooal oisliiLulion of cosls is nol nocossaiy,
Lul makos aggiogalion simploi ano is onough foi oui poinl. NolaLly, in oquiliLiium
no cosl will Lo paio sinco agonls who pailicipalo faco a cosl of zoio, ano agonls
who woulo havo lo pay lho cosl chooso nol lo pay il. As in lho moool of Soclion
8, consumplion of lypo-S agonls oLoys a slanoaio Luloi oqualion, which foi lho
iiskloss Lono ioaos:
(A.1)
1
1
|
= 1
|
_
A
S
|,|l
1ypo-H agonls faco lho following oplimalily conoilion:

(1 /)
1
1
|
1
|
_
A
1
|,|l
1
(1 /)
1
1
|
SuLsliluling foi 1
|
fiom(.1) wo havo: 1/ 1
|
_
A
1
|,|l
,1
|
_
A
S
|,|l
(1 /)
l
,
which wilh log ulilily Locomos:
1 /
C
1,|
1
|
_
C
l
1,|l
_
C
S,|
1
|
_
C
l
S,|l
_
1
1 /
Wo will look foi a minimum lovol of lho piopoilional liansaclion cosl

/ lhal makos
lho moasuio of housoholos al a coinoi solulion holoing no assols (foi which lho aLovo
is a sliicl inoqualily) Lo piocisoly `. Assuming log-noimalily ano homoskooaslicily,
wo can appioximalo lo socono oiooi lhis lowoi Louno on cosls Ly
(A.2)

/ -
1
|
^c
S,|l
1
|
^c
1,|l

1
2
_
o
2
1
o
2
S
_
0,
whoio o
2
= ar (c
,|l
1
|
c
,|l
) ano lowoicaso lollois oonolo logs. Nolo lhal
sinco consumplion giowlh is slalionaiy,

/ is Lounooo aLovo (applying lho liianglo
inoqualily lo (.2)).
Lqualion (.2) can Lo compaioo lo oala as follows. Givon an oLsoivoo non-
pailicipalion ialo ` ano limo soiios on consumplion of assol-holoois ano non-assol
holoois c
S,|
, c
1,|
, ono can compulo lho valuo of lho cosl lhal woulo oxplain lhis
pailicipalion sliucluio. 1his valuo can lhon Lo compaioo lo aclual liansaclion
cosls. Howovoi, moasuiomonl issuos aLouno iolaloo Lolh lo classifying housoholos
iolalivo lo lhoii assol-holoing slalus ano lo lnoing an appiopiialo moasuio of lho
cosl. Inoooo, mosl cosls lhal piovonl an agonl holo any assol al all aio likoly lo Lo
non-pocuniaiy ano iolaloo lo infoimalion impoifoclions, limo sponl unooislanoing
lho way assol maikols woik, olc. An alloinalivo ioulo is lo solvo foi lho momonls
involvoo in (.2) in a oynamic gonoial oquiliLiium fiamowoik as funclions of fun-
oamonlal shocks, foi a givon lovol of no-pailicipalion

`. 1hon, foi lho assumoo

`
lhoio oxisls a minimum lovol of lho cosl

/ ialionalizing il lhal can Lo founo Ly
solving (.2) .
Finally, nolo lhal as iogaios shaioholoing, lho cosl lhal piovonls housoholos
pailicipalo fiom lho slock maikol nooos lo Lo laigoi lhan

/, ouo lo lho oxis-
lonco of an oquily piomium. In lho fiamowoik of Soclion 8, lho Luloi oqua-
lion foi shaios of agonls who faco a zoio cosl is 1 = 1
|
_
1
.
|l
A
S
|,|l
, whoio
1
.
|l
= (\
|l
1
|l
1
|l
) ,\
|
is lho gioss ioluin on shaios. Agonls facing a cosl
/
.
chooso nol lo holo shaios \
1,|
= 0 il 1 /
.
1
|
_
1
.
|l
A
1
|,|l

_
1 /
.
_
l
.
1aking socono-oiooi appioximalions unooi assumplions of joinl conoilional lognoi-
malily ano homoskooaslicily as aLovo yiolos a lowoi Louno foi lho liansaclion cosl
in lho slock maikol:
/
.
-
1
|
^c
S,|l
1
|
^c
1,|l

1
2
_
o
2
1
o
2
S
_
o
.S
o
.1
whoio o
.
= co
_
r
.
|l
1
|
r
.
|l
, c
,|l
1
|
c
,|l
_
can Lo compuloo fiom lho gon-
oial oquiliLiium moool, as Lofoio. 1ho Lollomlino is lhal a coilain lovol of non-
pailicipalion ` can Lo ialionalizoo Ly piopoilional liansaclion cosls

/, /
.
.
AendIx H. Log-IInearIzed equIIILrIun
Foi assol holoois, wo havo lho Luloi oqualion, inlialompoial ano Luogol con-
sliainl (d
|
aio ioal piolls as a shaio of sloaoy-slalo GDI, d
|
= (1
|
1) ,1 ano
wo alioaoy imposoo lhal lho oquiliLiium valuo of shaio holoings \ is
l
lX
):
1
|
c
S,|l
c
S,|
= r
|
1
|
|l
, (L.1)
,:
S,|
= n
|
c
S,|
, (L.2)
C
S
1
c
S,|
=
\
1

S
1
(n
|
:
S,|
)
1
1 `
d
|
. (L.8)
Foi non-assol holoois, wo havo lho inlialompoial oplimalily conoilion ano Luo-
gol consliainl:
:
1,|
= 0, (L.4)
c
1,|
= n
|
. (L.)
Foi lims:
j
|
= (1 1
Y
) :
|
(1 1
Y
) a
|
, (L.6)
:c
|
= n
|
a
|
, (L.7)
d
|
=
1 1
Y
1 j
:c
|

j
1 j
j
|
, (L.8)
|
= ,1
|
|l
c:c
|
, c =
(1 0) (1 0,)
0
. (L.0)
LaLoui maikol cloaiing implios (: =laLoui oomano Ly lims):
(L.10) :
|
=
(1 `)
S
:
S,|
.
Aggiogalo consumplion is:
(L.11) c
|
=
`C
1
C
c
1,|

(1 `) C
S
C
c
S,|
.
LquiliLiium in gooos maikol holos Ly Walias` law (ano is ioounoanl onco oquiliL-
iium in all olhoi maikols has Loon imposoo).
(L.12) j
|
= c
|
.
Monolaiy policy iulo is:
(L.18) r
|
= c
t
1
|
|l
c
r
r
|
-
|
.
whoio -
|
aio policy shocks, i.o. movomonls in nominal ialos coming foim anylhing
olso lhan syslomalic iosponso lo inlalion oi oulpul gap.
H.1. Steady state.
1 =
1
,
whoio 1 = 1 r
\
1
=
1 1
'C
1
=
1
1
J
Y
1 j
1
1
=
j 1
Y
1 j
Wo assumo houis aio lho samo foi lho lwo gioups in sloaoy slalo only,
1
=
S
=
.1hon, foi lho log-linoai Luogol consliainls of Lolh agonls lho coomcionls aio
fully ooloiminoo:
\
1

S
1
=
1 1
Y
1 j
;
C
S
1
=
1 1
Y
1 j

j 1
Y
1 j
1
1 `
=
1
1 `
_
1 `
1 1
Y
1 j
_
\
1
11
=
C
1
1
=
1 1
Y
1 j
LIMI1LD ASSL1 MAIKL1S IAI1ICIIA1ION AND MONL1AIY IOLICY. A-
H.2. DerIvIng tLe IS-AS systen. Wo sook lo oxpioss ovoiylhing in loims of
aggiogalo vaiiaLlos, ano lhon uso lho lwo oynamic oqualions lo gol oynamics only
in loims of oulpul, inlalion ano inloiosl ialo. Fiisl, liy lo oxpioss consumplion
of assol holoois as funclion of aggiogalo vaiiaLlos, fiom (1.), (1.10),(1.11) using
lho sloaoy slalo coomcionls jusl calculaloo:
(L.14) c
S,|
=
1
1 `
C
C
S
j
|
`
1 `
C
1
C
S
n
|
SuLsliluling lhis, logolhoi wilh(1.10) inlo (1.2) ano using lho pioouclion funclion
wo gol:
n
|
= j
|
(1 1
Y
) ( 1) a
|
, (L.1)
whoio =
_
1 ,
C
S
C
1
1 1
Y
_
=
_
1 ,
1
1 `
1
1 1
Y
_
1 `
1 1
Y
1 j
__
_ 1.
SuLsliluling Lack inlo (1.14) ano using lho sloaoy slalo consumplion shaios wo
gol consumplion of assol-holoois as a funclion of oulpul:
c
S,|
= cj
|
(1 1
Y
) (1 c) a
|
, c = 1 ,
`
1 `
1
1 j
Nolo = c ,
l
lX
l
lJ`
. Wo jusl nooo lo ioplaco lhoso lasl lwo oqualions in lho
Luloi ano Now Koynosian Ihilips cuivo lo oLlain a syslom in oulpul ano inlalion.
Wo will wiilo lho wholo syslom in loims of lho oulpul gap (oiloionco of aclual
oulpul fiom oulpul unooi loxiLlo piicos) as is usually oono in lho liloialuio. Ioal
maiginal cosl is givon Ly :c
|
= n
|
a
|
; sinco in lho loxiLlo-piico oquiliLiium
lhis is conslanl (ano so is lho maikup) wo soo oiioclly fiom (1.1) lhal naluial
oulpul is: j
|
=
_
1 1
Y
_
1
l
_
__
a
|
, so maiginal cosl is iolaloo lo lho oulpul gap
r
|
= j
|
j
|
Ly:
(L.16) :c
|
= (j
|
j
|
) c
l
n
|
= r
|
c
l
n
|
.
whoio, following Claiioa, Gal ano Goilloi (1000) oi Gal (2002) wo also inlioouco
cosl-push shocks n
|
= c
l
n
|
, i.o. vaiialions in maiginal cosl nol ouo lo vaiialions
in oxcoss oomano. 1hoso coulo como fiom lho oxislonco of slicky wagos cioaling
a limo-vaiying wago maikup, oi olhoi souicos cioaling lhis inomcioncy woogo al-
lhough wo oo nol moool lhis oxplicilly hoio. SuLsliluling consumplion of assol
holoois in lho Luloi oqualion, wo can wiilo
(L.17)
c1
|
r
|l
= cr
|
[r
|
1
|
|l
[ (1 1
Y
) (1 c) [a
|
1
|
a
|l
[ c
_
1
|
j
|l
j
Wo oolno lho naluial ialo of inloiosl (Wicksollian inloiosl ialo) r
|
as lho lovol of
lho inloiosl ialo consislonl wilh oulpul Loing al ils naluial lovol (ano honco wilh
zoio inlalion), as in Wooofoio (2008). Solving fiom (1.17) wo oLlain:
(L.18) r
|
=
_
1 1
Y
_
1
c
__
[1
|
a
|l
a
|
[
Using(1.16) ano (1.18) inlo lho Now Koynosian Ihilips cuivo ano lho (1.17)
wo gol lho iooucoo syslom:
|
= ,1
|
|l
ir
|
n
|
, whoio i = c (L.10)
1
|
r
|l
= r
|
c
l
[r
|
1
|
|l
r
|
[ (L.20)
1ho moool is closoo Ly lho policy iulo (1.18) .
AendIx C. IrooI oI IroosItIon 1
Nocossaiy ano sumcionl conoilions foi ooloiminacy aio as follows (givon in
Wooofoio Apponoix lo Chaploi 4). Lilhoi Case A: (a) ool 1; (/) ool
tr 1 ano (c) ool tr 1 oi Case H: (1a) ool tr < 1 ano
(1/) ool tr < 1. Foi oui foiwaio -looking iulo caso, lho ooloiminanl ano
liaco aio:
ool = ,
l
1 (C.1)
tr = 1 ,
l
,
l
c
l
i(c
t
1)
Imposing lho ooloiminacy conoilions in Caso A aLovo (whoio Caso L can Lo iuloo
oul ouo lo sign iosliiclions), wo oLlain lho ioquiiomonl foi oquiliLiium uniquonoss:
c
l
(c
t
1)
_
0,
2 (1 ,)
i
_
1his implios lho lwo casos in Iioposilion 1: Caso I: c 0, c
t

_
1, 1 c
2(lo)
r
_
,
which is a non-omply inloival; Caso II: c < 0, c
t

_
1 c
2(lo)
r
, 1
_
. Nolico lhal (i)
1 2c (1 ,) ,i < 1 so lho inloival is non-omply; (ii) 1 2c (1 ,) ,i 0 implios
insloao lhal wo can iulo oul an inloiosl ialo pog, whoioas a pog is consislonl wilh
a uniquo ILL foi 1 c
2(lo)
r
< 0. 1ho lasl conoilion insloao holos if ano only if
` _
_
1
l
lJ
`
,
(l0)(lo0)
(l0)(lo0)
_
,
_
1
l
l
,
_
_
_
1
l
l
,
_
l
.
Whon lhis conoilion is nol fulllloo, wo havo 0 < 1 c
2(lo)
|
< 1, so lhoio
slill oxisl policy iulos c
t

_
1 c
2(lo)
|
, 1
_
Liinging aLoul a uniquo ialional ox-
poclalions oquiliLiium. Lul in lhis caso an inloiosl ialo pog, ano any policy iulo
wilh loo woak a iosponso c
t

_
0, 1 c
2(lo)
|
_
is nol compaliLlo wilh a uniquo
oquiliLiium.
C.1. DeternInacy roertIes oI a sInIe TayIor ruIe. Wo consiooi iulos
of lho foim:
(C.2) r
|
= c
t
|
-
|
Ioplacing lhis in lho IS oqualion (L.20) ano using lho samo molhoo as pioviously
wo oLlain lho following Iioposilion.
Inoioi1io: . n .n: :n :&| &h n (C.2) J|.: n &n.j& :n.nn|
rn.n j&.|.h:.&n .J nnJ n|j .J:
n 1: 1J c 0, c
t
1 ;h `Jnj|: 1:.n.|`)
n 11: 1J c < 0,
c
t

_
0, min
_
1, c
, 1
i
, c
2 (1 ,)
i
1
__
'
_
max
_
1, c
2 (1 ,)
i
1
_
,
_
Il luins oul lhal lho ìnvoiloo 1ayloi piinciplo` holos in Caso II foi a somowhal
laigoi shaio of non-assol holoois lhan was lho caso unooi a foiwaio-looking iulo.
Inooi. SuLsliluling lho 1ayloi iulo in lho IS oqualion ano wiiling lho oy-
namic syslom in lho usual way foi lho .
|
= (j
|
,
|
)
vocloi of onoogonous vaiiaLlos

ano lho i
|
= (-
|
r
|
, n
|
)
vocloi of oisluiLancos :
1
|
.
|l
= .
|
wi
|
1ho coomcionl maliicos aio givon Ly:
=
_
1 ,
l
c
l
i c
l
_
c
t
,
l
_
,
l
i ,
l
_
ano w =
_
c
l
0
0 ,
l
_
Doloiminacy ioquiios lhal Lolh oigonvaluos of Lo oulsioo lho unil ciiclo. Nolo
lhal:
ool = ,
l
_
1 c
l
ic
t
_
ano tr=1 ,
l
_
1 c
l
i
_
Foi Caso A wo havo: (Aa) implios:
c
l
c
t

, 1
i
(AL) implios
c
l
(c
t
1) 0
(Ac) implios
c
l
(1 c
t
)
2 (1 ,)
i
1ho ooloiminacy ioquiiomonls aio as follows. Fiisl, nolo lhal (AL) moioly ioquiios
lhal c
l
ano (c
t
1) havo lho samo sign. Honco, wo can oislinguish lwo casos:
Caso I: c
l
0, c
t
1. 1ho slanoaio caso is oncompassoo hoio ano lho 1ayloi
piinciplo is al woik as ono woulo oxpocl. 1ho olhoi conoilions aio aulomalically
salisloo, sinco Lolh c
l
c
t
ano c
l
(1 c
t
) aio posilivo, ano
ol
r
,
2(lo)
r
< 0.
Caso II: c
l
< 0, c
t
< 1. Conoilion (Aa) implios (nolo lhal sinco c < 0
lho iighl-hano quanlily will Lo posilivo): c
t
< c
ol
r
. 1ho lhiio ioquiiomonl foi
uniquonoss (Ac) implios: c
t
< c
2(lo)
r
1. Sinco c
t
_ 0, lhis lasl ioquiiomonl
implios a fuilhoi conoilion on lho paiamoloi spaco, namoly c
2(lo)
r
1 _ 0.
Ovoiall, lho ioquiiomonl foi ooloiminacy whon c
l
< 0 is honco:
(C.8) 0 _ c
t
< min
_
1, c
, 1
i
, c
2 (1 ,)
i
1
_
Caso L, insloao, involvos fulllmonl of lho following conoilions: (1a) implios c
l
(c
t
1) <
0 ano (1/) implios c
l
(1 c
t
) <
2(lo)
r
. Nolo lhal in Caso I, whoioLy c
l
0,
lhoso conoilions cannol Lo fulllloo ouo lo sign iosliiclions (lhis is lho caso in a slan-
oaio oconomy as in Wooofoio (2008), o.g.). In Caso II howovoi, lho lwo conoilions
imply:
(C.4) c
t
max
_
1, c
2 (1 ,)
i
1
_
C.8 ano C.4 logolhoi imply lho following ovoiall ooloiminacy conoilion foi lho
policy paiamoloi:
c
t

_
0, min
_
1, c
, 1
i
, c
2 (1 ,)
i
1
__
'
_
max
_
1, c
2 (1 ,)
i
1
_
,
_
1o assoss lho magniluoo of policy iosponsos nooooo foi ooloiminacy as a func-

lion of ooop paiamolois, wo can oislinguish a fow casos foi oiloionl paiamoloi
iogions (nolo lhal wo aio always looking al lho suLspaco whoioLy c
l
< 0):
Shaio of non-assol holoois Doloiminacy conoilion
` <

`
l
c
t
1
`
_
`
l
,
`
2
_
c
t

_
0, c
2(lo)
r
1
_
' (1, )
`
_
`
2
,
`
3
_
c
t

_
0, c
ol
r
_
' (1, )
`
_
`
3
,
`
d
_
c
t

_
0, c
ol
r
_
'
_
c
2(lo)
r
1,
_
`
_
`
d
, 1
_
c
t
[0, 1) '
_
c
2(lo)
r
1,
_
whoio
`
I
=
_
1
1
1 1
Y
,
(1 0) (1 ,0)
/
I
(0)
_
,
_
1
1
1 j
,
_
/
l
(0) = (1 0) (1 ,0) ; /
2
(0) = 1 ,0
2
2,0; /
3
(0) = 1 ,0
2
; /
d
(0) = 1 ,0
2
0.2
0.4
0.6
0.8
1
0 0.2 0.4 0.6 0.8 1

S
=1
S
=10
Fig.4: 1hiosholo valuo foi shaio of non-assol holoois making ooloiminacy
conoilions clososl lo Invoiloo 1ayloi Iiinciplo.
Wo plol lho lasl caso `
_
`
d
, 1
_
; c
t
[0, 1) '
_
c
2(lo)
r
1,
_
in Figuio
4 aLovo, whoio lho iogion aLovo lho cuivo ano Lolow lho hoiizonlal lino givos pa-
iamoloi comLinalions compaliLlo wilh lho aLovo conoilion. 1ho oiloionl cuivos
coiiospono lo oiloionl laLoi supply olaslicilios (, = 1 oolloo lino ano , = 10
lhick lino). In viow of usual oslimalos of ` in lho liloialuio (o.g. 0.4-0. CampLoll
ano Mankiw (1080)) wo shall consiooi lhis caso as lho mosl plausiLlo. Whonovoi
lhoso paiamoloi iosliiclions aio mol, ooloiminacy is insuioo Ly oilhoi a violalion
of lho 1ayloi piinciplo, oi foi a sliong iosponso lo inlalion. Howovoi, nolo lhal
lho lowoi Louno on lho inlalion coomcionl lhon Locomos voiy laigo (8. 488 unooi
lho Lasolino caliLialion), which is fai fiom any ompiiical oslimalos. Inoooo, lho
lhiosholo inlalion coomcionl is shaiply incioasing in lho shaio of non-assol holo-
ois ano invoiso olaslicily of laLoi supply, as can Lo soon Ly moioly oiloionlialing
c
2(lo)
r
1 wilh iospocl lo lhoso paiamolois.
AendIx D. IrooI oI IroosItIon 3: derIvatIon oI aggregate veIIare
IunctIon
Assumo lho sloaoy-slalo is omcionl ano oquilaLlo, in lho sonso lhal consump-
lion shaios acioss agonls aio oqualizoo. 1his is onsuioo Ly having a lscal aulhoiily
laxsuLsioizo salos al lho conslanl ialo t ano iooisliiLulo lho piocoooings in a
lump-sum fashion T such lhal in sloaoy-slalo lhoio is maiginal cosl piicing, ano
piolls aio zoio. 1ho pioll funclion Locomos 1
|
(i) = (1 t) [1
|
(i),1
|
[ 1
|
(i)
('C
|
,1
|
)
|
(i) T
|
, whoio Ly Lalancoo Luogol T
|
= t1
|
(i)1
|
(i). Lmcioncy io-
quiios t = j, such lhal unooi loxiLlo piicos 1
|
(i) = 'C
|
ano honco piolls aio
1
|
(i) = 0. Nolo lhal unooi slicky piicos piolls will nol Lo zoio sinco lho maik-up
is nol conslanl. Unooi lhis assumplion wo havo lhal in sloaoy-slalo:
\
(
1
)
l
(C
1
)
=
\
(
S
)
l
(C
S
)
=
\
1
= 1 =
1
,
whoio
1
=
S
= = 1 ano C
1
= C
S
= C = 1.
Supposo fuilhoi lhal lho social plannoi maximizos a convox comLinalion of lho
ulililios of lho lwo lypos, woighloo Ly lho mass of agonls of oach lypo: l
|
(.) =
`l
1
(C
1,|
,
1,|
) [1 `[ l
S
(C
S,|
,
S,|
). A socono-oiooi appioximalion lo lypo
,
: ulilily aiouno lho omcionl lox-piico oquiliLiium oolivois:
l
,|
= l
(C
,|
,
,|
) l
_
C
,|
,
,|
_
=
= l
c
C
C
,|

1
2

C
2
,|
(1 ) c
,|

C
,|
_
,|

1 ,
2

2
,|
(1 ,) :
,|

,|
_
t.i.j O
_
| |
3
_
,
whoio vaiiaLlos wilh a hal oonolo log-oovialions fiom lho lox-piico lovol (oi `gaps`)
C
|
= log
ct
c
t
= c
|
c
|
, ano vaiiaLlos wilh a slai lox-piico valuos as aLovo c
|
=
log
c
t
c
. Nolo lhal sinco l
c
C
1
= l
c
C
S
ano \
1
= \
S
ano using c
1,|
=
c
S,|
= c
|
(which holos sinco assol incomo in lho lox-piico oquiliLiium is zoio, as
piolls aio zoio) wo can aggiogalo lho aLovo inlo:
l
|
= l
c
C
_
C
|
(1 ) c
|

C
|

1
2
_
`
C
2
1,|
(1 `)

C
2
S,|
_
_
|
(1 ,) :
|

1 ,
2
_
`

2
1,|
(1 `)

2
S,|
_
_
t.i.j O
_
| |
3
_
Nolo lhal

C
|
=

1
|
ano

|
=

1
|
^
|
, whoio ^
|
is piico oispoision as in Wooofoio
(2008) , ^
|
= log
_
l
0
(1
|
(i) ,1
|
)
:
di. Sinco l
c
C = \
wo can show lhal lho

linoai loim Loils oown lo:
l
c
C
_
C
|
(1 ) c
|

C
|
_
\
|
(1 ,) :
|
_
= l
c
C
_
1
|
( 1) c
|

1
|

1
|
^
|
(1 ,) :
|

1
|
_
O
_
| |
3
_
= l
c
C [^
|
[ O
_
| |
3
_
Quaoialic loims can Lo oxpiossoo as a funclion of aggiogalo oulpul. Foi lhal pui-
poso, nolo lhal in ovalualing quaoialic loims wo can uso lisl-oiooi appioximalions
of lho oplimalily conoilions (highoi oiooi loims woulo imply loims of oiooi highoi
lhan 2, iiiolovanl foi a socono-oiooi appioximalion). Up lo lisl oiooi, wo havo
lhal

C
1,|
= (1 j)

\
|
,

1,|
= j

\
|
ano

\
|
= ,

|
(1 )

C
|
= (, )

1
|
,^
|
so:
C
2
1,|
= (1 ,)
2

1
2
|
O
_
| |
3
_
2
1,|
= (1 )
2

1
2
|
O
_
| |
3
_
C
2
S,|
=
1
(1 `)
2
[1 `(1 ,)[
2

1
2
|
O
_
| |
3
_
2
S,|
=
1
(1 `)
2
[1 `(1 )[
2

1
2
|
O
_
| |
3
_
1ho aggiogalo :-:.J wolfaio funclion is lhonco, up lo socono oiooi (ignoiing
loims inooponoonl of policy ano of oiooi laigoi lhan 2):
l
|
= l
c
C
_
1
2
_
`
C
2
1,|
(1 `)

C
2
S,|
_
1 ,
2
_
`

2
1,|
(1 `)

2
S,|
_
^
|
_
= l
c
C
_
1
2
,
1 `
[1 `(1 ) (1 ,)[

1
2
|
^
|
_
1ho inloilompoial oLjoclivo funclion of lho plannoi will honco Lo
|
=
I=|
l
|I
.
1his is consislonl wilh oui viow lhal limiloo pailicipalion lo assol maikols comos
fiom consliainls ano nol piofoioncos. In lho lalloi caso, maximizing inloilompoially
lho ulilily of non-assol holoois woulo Lo haio lo juslify on wolfaio giounos. How-
ovoi, nolo lhal foi lho oisciolionaiy (Maikov) oquiliLiium sluoioo hoio, lhis choico
makos no oiloionco sinco loims fiom limo t 1 onwaios aio lioaloo paiamoliically
in lho maximizalion ano lho limo-t oLjoclivo funclion is ioonlical ano oqual lo

l
|
.
Ly usual aigumonls ioaoily availaLlo olsowhoio (soo Wooofoio (2008), Gal ano
Monacolli (2004)) wo can oxpioss piico oispoision as a funclion of lho cioss-soclion
vaiianco of iolalivo piicos: ^
|
= (-,2) \ ar
I
(1
|
(i) ,1
|
) ano lho (piosonl oiscounloo
valuo of lho) cioss-vaiianco of iolalivo piicos as a funclion of lho inlalion ialo
|=0
,
|
\ ar
I
(1
|
(i) ,1
|
) = c
l
|=0
,
|
2
|
. Honco, lho piosonl oiscounloo valuos of
piico oispoision ano lho inlalion ialo aio iolaloo Ly
|=0
,
|
^
|
= (-,2c)
|=0
,
|
2
|
ano lho inloilompoial oLjoclivo funclion Locomos (6.1) in Iioposilion 8 (ioinlio-
oucing lho nolalion

1
|
= r
|
).
AendIx E. CycIIcaI InIIcatIons and sunsot equIIILrIa
1ho conoilion foi piolls cyclicalily usoo in loxl is ooiivoo as follows, using lho
oxpiossion foi piolls (1.8) ano lho iolalionship Lolwoon maiginal cosl ano oulpul
gap:
JJ
J
0 =

l

lJ`
l
Jnc
J
0 =
Jr
J

Ju
J
<

lJ
`
=
_
1
J
J
_

Ju
J
<
lJ
`
=
J
J

lJ
`

Ju
J
J,0
= dj <
_(lJ
`
)
_(lJ
`
)(lJ
`
)Ju
dj
. In loims
of oulpul gap: dr <
(lJ` )Ju
_(lJ` )(lJ` )Ju
dj
whoio lho iighl-hano sioo loim is

oxogonous ano ooponos on lochnology.
1ho slaLilily conoilion in lho caso of inooloiminacy is - soo LuLik ano Schoifhoioo
(2008), p. 278 (whoio [[
2.
oonolos lho socono iow of lho maliix, allachoo lo
lho oxplosivo compononl):
_
J
l
w
2.
i
|

_
J
l
I
2.
j
|
= 0
Sliaighlfoiwaio algoLia lo calculalo
_
J
l
w
2.
=
1
_
ic
l
,
l

_
J
l
I
2.
=
1
_
i
1

oolivois lho slaLilily conoilion as:
ic
l
(-
|
r
|
)
_
,
l
_
n
|
i
|
(
1) j
t
|
= 0
Sinco only ono iool is suppiossoo, lhoio is onoogonous poisisloncy of lho olocls of
shock (which was nol lho caso unooi ooloiminacy).
Following LuLik ano Schoifhoioo (2008) wo compulo a singulai valuo oocom-
posilion of (
)
_
J
l
I
2.
:
_
J
l
I
2.
= 1
_
d 0

_
rj
J
jl
J
j
l
J
rj
J
_
d =
_
(i
)
2
(
1)
2
Using also , (
)
_
J
l
w
2.
=
_
ic
l
,
l

wo gol lho full sol of slaLlo
solulions as oosciiLoo in loxl.

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LAMP Theory

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LInIted Asset Aarkets IartIcIatIon, Aonetary IoIIcy and

{Inverted) KeynesIan LogIc.

. Lmpiiical suppoil foi oui mooolling

In an apponoix, wo oullino a simplo moool in which high onough piopoilional liansaclion

(whoio lho lalloi is givon Ly (4.1)) wo aio in a `Koynosian` iogion,

vocloi of onoogonous vaiiaLlos ano lho

vocloi of oisluiLancos is oLlainoo Ly ioplacing (.1) inlo (4.2)

Taylor Principle Restored

. 1ho coomcionl maliicos , aio slill lho

) < [j, ((1 1

0, Lul lho policy

piolls aio always piocyclical in lho non-Koynosian

will Lo insioo lho unil

1. 1his can Lo shown lo Lo lho caso if oilhoi (i) c 0, c

1). 1ho olocls of policy shocks, ano of shocks lo lho

. 1ho oplimalily con-

1ypo-H agonls faco lho following oplimalily conoilion:

Wo oolno lho naluial ialo of inloiosl (Wicksollian inloiosl ialo) r

vocloi of onoogonous vaiiaLlos

1o assoss lho magniluoo of policy iosponsos nooooo foi ooloiminacy as a func-

: ulilily aiouno lho omcionl lox-piico oquiliLiium oolivois:

wo can show lhal lho

whoio lho iighl-hano sioo loim is

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