Flexibility in an inflation targeting regime under demand shocks:

a model with endogenous potential output from the demand side

Ricardo Ramalhete Moreira1

Abstract: In the spirit of Sawyer (2002), Lavoie (2006) and Fontana & Palacio-Vera
(2007), among others, this article aims to demonstrate that, under the hypothesis of an
endogenous potential output from the demand side, there are social losses that are not
analyzed by conventional inflation targeting models when central banks attack demand
shocks. If there is an endogenous potential output from the demand side, central banks
should take it into account when setting their strategy and monetary policy rule. By
doing so, central banks attain higher economic performance, in comparison with central
banks that do not implement the required changes in their instrument rule.
Key-words: inflation targeting; demand shocks; endogenous potential output.
JEL: E17; E52.
1 - Introduction
The conventional literature about the Inflation Targeting regime presents some motives
for more flexible arrangements. A flexible regime could be justified, for example, under
supply shocks (Ball, 1999a). In such a case, the reduction of the inflation rate implies a
decreasing output level, or, in other words, reductions of inflation volatility imply
increase of output volatility. There is a trade-off between these two variables (Clarida,
Gal & Gertler, 1999). Hence, central banks have reasons to accommodate supply
shocks, either partially or integrally, in order to maintain output and employment levels.
An additional reason central banks have for becoming a more flexible IT regime is
interest rate smoothing, or the public preference for making interest rates more stable.
This kind of preference occurs when the public is concerned about financial market
health (Blinder, 2006). In cases in which financial institutions present some type of
fragility, interest rate volatility may create a bankruptcy cumulative process. In such a
context, central banks may prefer to accommodate inflationary shocks so as to avoid
interest movements and financial disasters.
Another kind of motive in favor of IT flexibility is public preference for exchange rate
stability. Interest rate movements have direct effects on exchange rate levels: the more
volatile the former, the more volatile the latter, in a flexible exchange regime. Given the
high velocity by which interest rate affects exchange rate, and the strong correlation
between the latter and the inflation rate, if the IT regime is a strict or rigid regime,
central banks are forced to counter inflationary processes affecting exchange rates as
quickly as possible, creating exchange rate volatility. On the other hand, exchange rate
volatility may complicate external trade and cause problems, especially in emerging
economies, in which exports have a heavy impact on GDP, or when domestic agents
have debts denominated in foreign currencies. Hence, as a means of avoiding exchange
1

Professor Adjunto no Departamento de Economia da UFES. Doutor em Economia pela UFRJ.

ramalhete.s@gmail.com

rate volatility in open economies, central banks look to accommodate part of the
inflationary shocks, and by doing so minimize social losses (Ball, 1999b).
Additionally, the literature also presents arguments for the flexibility of an IT regime as
a consequence of structural uncertainty (Brainard, 1969; Blinder, 2006). Uncertainty
means that central banks have problems making forecasts about the future effects of
current movements in interest rates. This happens because central banks simply do not
know how economies work in an exact measure. In other words, there is uncertainty as
to the parameters that define the direction and velocity of causal relationships. In a
structural uncertainty environment, monetary authority prefers to be gradualist,
adjusting its instrument with lower magnitude if compared with the suggestion of
optimal rules.
In all of these cases above, the literature agrees with the notion of a flexible IT regime,
and its corresponding adjusted instrument rule, as well as with additional mechanisms
of decision making. However, it remains a special case to which the conventional
literature sees no reason for flexibility: the case of demand shocks, or more specifically,
the case in which the inflationary process is caused by output gaps. Clarida, Gal &
Gertler (1999), Svensson (1997), Ball (1999a) and Bofinger, Mayer & Wollmershaeuser
(2006) advocate an integral elimination of demand shock through interest rate
responses. In their vision, demand shocks do not impose a trade-off between social
objectives and monetary policy responses would eliminate inflation and output gaps
simultaneously. There would be no social costs as a consequence of these responses.
This article is an attempt to reject the conventional theoretical result, according to which
there is no social cost as an effect of a monetary policy that wholly (or partly) eliminates
demand shocks. It will be demonstrated that this conventional conclusion requires the
natural rate hypothesis: that is, the hypothesis by which potential output does not have a
correlation with demand and current output fluctuations. It will be shown that, if the
economic system operates under an endogenous potential output from the demand side,
the IT regime should be flexible even in the case of demand shocks. A strict IT regime
under such conditions imposes a social cost, translated by potential output losses in the
long term. It will be assumed that endogenous potential output from the demand side is
closer to the true structural model than the natural rate hypothesis.
Moreover, some preliminary words are convenient: in our view, following Svensson
(2003), central banks in practice do not know the true structural model, and so they do
not implement optimal instrument rules. Hence, in this article, we propose a structural
model that will be considered an adequate approximation to the true structural model,
borrowing Walshs (2003) words, under a policy process in which central banks have
incomplete information about how the economic system actually works. Specifically,
our short simulation will run two different ad hoc instrument rules. Although these two
rules (a Taylor rule and an alternative rule) are not derived by optimization problems,
they will be regarded as good approximations of how two distinct kinds of central bank
implement their monetary policy.
On the other hand, it is important to stress that this article is not an attempt to verify
empirically or present eventual evidence concerning endogenous potential output by the
demand side in the long term. This article intends specifically to test theoretically the
effects of such an endogenous potential output by the demand side under demand
2

shocks and their implications on inflation targeting regimes. Therefore, discussing the
empirical appeal of this hypothesis is not under consideration, at least in this context.
The general view of this article is compatible with recent kaleckian and post-keynesian
works of Sawyer (2002), Lavoie (2006) and Fontana & Palacio-Vera (2007), among
others, although specific assumptions or results may not be the same.
The article is structured in the following way: Section 2 presents a conventional
inflation targeting model that will be used as a parameter for analysis of the main
elements under consideration; Section 3 introduces the notion of endogenous potential
output by the demand side in the model; Section 4 proposes a new instrument rule,
rather than a strict Taylor rule, for central banks dealing with demand shocks; Section 5
stresses what may be called opportunity social cost and its implications for the social
loss function behind monetary policy actions; Section 6 runs a small numeric
simulation, and by doing so it compares economic performance under two alternative
monetary policy regimes. Finally, the conclusions and references of the study are
presented.
2 - A conventional Inflation Targeting model
The conventional models of inflation targeting follow a general pattern. The economic
structure is translated by two stochastic dynamic equations, a dynamic IS curve and a
Phillips curve, which are complemented by a monetary policy rule2 (Taylor, 1994; Ball,
1999a; Hall & Mankiw, 1994; Svensson, 1997; Bofinger, Mayer & Wollmershaeuser,
2006; Gal & Gertler, 20073). This type of model pays special attention to the lagged
effects of monetary policy and the output and inflation inertia. The instrument rule or
monetary policy rule is considered optimal when it minimizes a weighted sum of the
inflation and output variances. Hence, the efficiency of a monetary policy rule could be
measured by its effects on the volatility of those macroeconomic variables. Let the IS
curve be:
(1) yt = m(yt-1) - n(rt-1) + t
The output gap (yt) depends on the lagged output gap (y t-1) and the lagged interest rate
deviation (rt-1); there is a demand shock, , a stochastic process with zero mean and
fixed variance (white noise process); all the parameters, m and n, are positives.
Additionally, let us consider the output gap as a deviation of the effective output (Y t) in
relation to potential output (Yp): yt = Yt - Ytp4. In the conventional model, as will be
better explained at a later point, potential output is constant in time, according to the
natural rate hypothesis. It is easy to note that the interest rate affects output only with a
2

Some authors prefer to specify these equations in a forward-looking form, proposing a fundamental role
to the publics expectations which, in their turn, are constructed by information optimization (rational
expectations) (in the same way as Clarida, Gal & Gertler, 1999). This article, on the other hand, adopts a
backward-looking specification of those equations, by proposing more importance to the inertia effects on
inflation and output.
3

Obviously, there are some differences with regard to specification among those works, but three
structural equations may be understood as an essence of this family of models.
4

In the same way, let rt-1 be the deviation of the real interest rate (Rt-1) vis--vis the natural interest rate
(Rn).

one-period lag, and that output presents inertia increasing with m. Now, let the Phillips
curve be:
(2) t = (t-1) + (yt-1) + gt
Equation (2) establishes that inflation rate deviation (t) is determined by its value in t-1
period (t-1), by the lagged output gap (yt-1) and by the supply shock (gt), defined as a
stochastic process with zero mean and fixed variance (white noise process); the
parameters, and , are positive. Here, inflation deviation means a divergence between
inflation rate ( t) and inflation target (n). Hence, t = t n.
It is possible to note from equation (1) that the policy decision made in the current
period affects the output gap with a one-period lag, and the output gap affects inflation
deviations with a one-period lag, through equation (2); hence, there are two-period lags
between the modification in the real interest rate set by the central bank, and its effects
on the inflation rate. Therefore, when the central bank decides what should be the new
real interest rate in the economy, the authorities take inflation rate expectations relative
to t+1 as a given, because the last one is not affected by monetary policy made in
current period (t period). These lag properties are especially focused in Ball (1999a) and
Svensson (1997; 1999), and express the backward-looking nature5 of the model.
The monetary policy, in its turn, is described trough an instrument rule, a typical Taylor
rule, such as:
(3) rt = z1t + z2 yt + u1t
Rule (3) establishes that the monetary authority reacts to inflation deviation and output
gap by adjusting the real interest rate; z1 and z2 are positives; u1t a random control error
(zero mean and constant variance). We do not consider inertia components (or
smoothing interest rates) in the policy instrument, but it does not alter qualitatively the
results of our work. The conventional literature also attains this kind of optimal
instrument rule by means of a first order condition for the minimization of a social loss
function (see Svensson, 1997; 1999). The central bank decides what the interest rate
should be based on information regarding current values of inflation and output, as well
as potential output and the inflation target.
Furthermore, instrument rule (3) is defined in real values, not in nominal values.
Implicitly, it supposes that central bank adjusts nominal interest rate in the exact
magnitude necessary for a desired variation in the real interest rate. This is the Taylor
principle, according to which the central bank reacts to inflation deviations by adjusting
real and not only nominal interest rates.
It is essential to understand that this type of analytical model takes the potential output
as given. In other words, the model assumes the natural rate hypothesis. This means
that positive or negative output gaps dont have any effect on the potential output,
because the latter is considered as a variable without correlation with money and
demand. Hence, when there is a positive output gap, for example, there are also inflation
5

Questions concerning the difference between backward-looking and forward-looking models will not be
analyzed here. A good reference that makes the issue clear is Clarida, Gal & Gertler (1999).

pressures through Phillips curve (2), but there is not any variation in potential output. In
such a context, monetary authority does not have any reason to accommodate output
and inflation deviations, and interest rate responses do not cause any social loss. The
central bank sees no motives for implementing a more flexible monetary policy under
demand shocks.
If the central bank increases real interest rates, there will be a decrease in output gap (1)
together with reductions in inflation deviation (2). The conventional literature about the
inflation targeting regime attempts to show that there is not a trade-off between output
and inflation variances under demand shocks, although it occurs under supply shocks.
Clarida, Gal & Gertler (1999) pose the issue as follows: That policy should offset
demand shocks is transparent from the policy rule. Here the simple idea is that
countering demand shocks pushes both output and inflation in the right direction.
Demand shocks do not force a short run trade-off between output and inflation.
(Clarida, Gal & Gertler, 1999, pp. 1674,5). In the same way, Thus, the model shows
that there is no trade-off between output and inflation in a situation of a demand shock.
(Bofinger, Mayer & Wollmershauser, 2006, pp. 100).
If potential output has no correlation with money, demand and actual output variations,
it is true that the central bank is able to push both output and inflation in the right
direction, without any social cost as a consequence of such a policy. However, if the
output gap has effects on potential output, such as those by means of induced private
investments, interest rate responses may imply some social cost that is not regarded by
the conventional literature6.
3 - Introducing endogenous potential output by the demand side
There is an alternative literature, and here it will be referred to as heterodox literature,
that considers potential output as endogenous from the demand side. It is endogenous
because private investments - induced by money, demand and current production levels
- inevitably have an effect on capital accumulation and productive trends, so on
potential output. Authors such as Kaldor (1956), Pasinetti (1962), Robinson (1962),
Kalecki (1971) and Dutt (1990; 1994) present private investment as a function of
variables such as profits/income ratio, degree of utilization of productive capacity and
capital productivity.
In the same way, Serrano (1995) aims to demonstrate how demand has an expressive
impact on real variables in the long term. It is just as important to note that there are
potential effects of demand and current output levels on production capacity, effects
considered in a specific tradition of economic thought, although this issue will not be
under an exhaustive analysis here.
More recently, Rowthorn (1999) and Sawyer (2002) have introduced endogenous
capital accumulation and a kind of an endogenous NAIRU (non accelerating inflation
rate of unemployment), under post-keynesian and kaleckian ideas, and have considered
the implications for the economic dynamic.
Rowthorn (op. cit.), motivated by a desire to understand why European unemployment
had remained persistently high since the shocks of the 1970s, proposed a model in
6

This literature is called the New Neoclassical Synthesis (as pointed out Goodfriend & King, 1997).

which investments are endogenised in a variety of ways, such as by real profit and
interest rates. The main conclusion Rowthorn (op. cit.) attains is that a permanent
reduction in the real interest rate leads to only a temporary acceleration in economic
growth but a permanent fall in unemployment. (Rowthorn, 1999, pp. 423), breaking off
with mainstream results.
In the same line, Sawyer (2002) focuses on the role of aggregate demand on the
determination of the dynamic of capital stock and employment within a context of some
form of NAIRU. By assuming non mainstream assumptions, Sawyer (op. cit.) argues
that there are long run relationships between inflation and unemployment, and between
this last one and the capital accumulation. The author wants to demonstrate that a
reduction in the NAIRU may be achieved with a sustained increase in the level of
aggregate demand to stimulate investment; and that the ideas according to which a
reduction of inflation (through control of the monetary policy instruments) can be
achieved without any detriment to the real side of an economy and that there is no long
run trade off between inflation and unemployment are both wrong.
Furthermore, Lavoie (2006) and Fontana & Palacio-Vera (2007), among others,
represent interesting contributions to the theme of the endogenous potential output or
endogenous natural rate of growth processes. Lavoie (2006), particularly, presents an
amendment to the new consensus or mainstream model by taking into account that The
natural rate of growth is ultimately endogenous to the demand-determined actual rate
of growth (Setterfield, 2002, pp. 5).
Lavoie (2006) argues that, as Len-Lesdema and Thirlwall (2002) have shown in an
empirical study for fifteen developed countries over the post-war period, when actual
demand growth diverges from the natural rate of growth it is created a change in the natural
rate that will make its value converging to the actual demand growth.
This idea generates the possibility of multiple equilibria, that make long-run supply
forces dependent on short run disequilibrium adjustment paths induced by effective
demand. (Lavoie, 2006, pp. 177). This is compatible with the assumption posed by
Len-Lesdema and Thirlwall: growth creates its own resources in the form of
increased labour force availability and higher productivity of the labour force (Len
Lesdema and Thirlwall, 2002, pp. 452).
Moreover, Fontana & Palacio-Vera (2007) study the implications of alternative
assumptions, such as unit root processes, hysteretic systems and multiple equilibria,
along with demand-led growth models, for the economic dynamic and monetary policy
strategy; the results found by the authors show that monetary policy does have longrun effects on output and employment (Fontana & Palacio-Vera, op. cit., pp. 294) and
the demand side of the market does matter in both the short and the long run (idem);
the authors suggested a flexible opportunistic approach which not only seeks to
stabilize output in the short run and achieve price stability in the long run but that also
makes an active contribution to the growth of output and employment (idem).
In its turn, here, the main theoretical question is: if an endogenous potential output from
the demand side is assumed, what are the implications for the inflation targeting
regime, with respect to instrument rules, demand shocks and social costs? Initially, it is
6

necessary to introduce the endogenous potential output in the conventional model

expressed through equations (1) - (3). Such an introduction may be seen as the
amendment of this work to the conventional inflation targeting model. Let the net
investment in fixed capital rate function be:
(4) it = It/Yt (It/Yt )* = (Yt-1 Ypt-1)
Equation (4) shows that net investment rate deviations (it) are a positive function of the
lagged output gap, given and Ypt-1the potential output in period t-1; and given
It/Yt (It/Yt )* is the difference between the actual net investment rate (I t/Yt) in period t
and the normal or desired net investment rate (It/Yt )* in the same period.
For simplicity, let the normal net investment rate be equal to zero ((It/Yt )* = 0), in such
a way that if Yt-1 Ypt-1 is equal to zero so the actual net investment rate in period t is
also zero (hence, if Yt-1 Ypt-1 = 0 then it = It/Yt = (It/Yt )* = 0)7. That is, there is an
accelerator effect in the determination of net private investments, and on the other hand
these same net investments are determining, one period ahead, the capital or potential
output formation, such as:
(5) Ypt = Ypt-1 + it-1 + t
Equation (5) illustrates the role of net investments in the potential output formation.
Potential output in period t is a function of its value in period t-1, lagged net investment
rate deviation (it-1) and a potential output shock (t), defined as a stochastic process with
zero mean and fixed variance (white noise process), that represents productivity and net
investment innovations.
If net investment rate deviation is zero, and shock is also zero, there is a constant
potential output between two periods (only because (It/Yt )* = 0 for simplicity). In this
case, there were only investments in the maintenance of the capital stock. By
substituting (4) for (5), an endogenous potential output function is created:
(6) Ypt = Ypt-1 + (Yt-2 Ypt-2) + t
Equation (6) shows that the output gap affects potential output two periods ahead. It
supposes that the output gap is caused by demand fluctuations, inducing higher net
investment rates above that level considered desirable in past periods. Obviously, the
model with an endogenous potential output from the demand side assumes > 0.
Hence, the model with exogenous potential output () may be thought of as a
particular case of analysis. Conventional inflation targeting theory would be attached to

In such a context, net investment is zero and there will be only investments in the maintenance of the
capital stock. Adopting (It/Yt )* equal to zero makes simpler the equation (5). Indeed, if we assumed a
positive value for normal net investment rate we would have to introduce a growth trend on potential
output, which could be done by imposing a parameter higher than unity on Ypt-1. Note that in equation (5)
implicitly this parameter is equal to unity, which is made possible only because we have assumed normal
net investment rate equal to zero.

the particular case in which there are no correlations between output gaps and potential
output, that is, to the long term money neutrality hypothesis8.
In its turn, if we accept the non neutrality hypothesis (), the IS curve receives a
new (implicit) specification9, because output is no longer subjected to a constant
maximum level of production; this maximum level varies with demand and output
fluctuations. Evidently, it is assumed that this hypothesis (non money neutrality) is
closer to the true structural model than the neutrality hypothesis.
4 - A new instrument rule
The issue related to endogenous potential output from the demand side becomes
especially important when considerations about demand shocks are proposed. These
kinds of shocks are expressed through output gaps, even if the economic system was, in
the previous periods, in an equilibrated trajectory. Output gaps and their inflationary
consequences, in their turn, may be highly persistent, depending on inertia parameters
(m e ), making the maintenance of price stability more difficult for the monetary
policy. It is not surprising that conventional theory about the inflation targeting regime
defends a rigid attack against demand shocks: as there is no correlation between output
gaps and potential output in this theory, and the inflationary process implicates social
costs, so monetary policy should not be benevolent with demand shocks and their
effects on the economy. Modifications in interest rates do not result in any cost to the
system and output and inflation volatilities are simultaneously eliminated.
However, if potential output is really under an effect of output gaps, interest rate
responses should be adjusted, that is, if there is endogenous potential output from the
demand side, the central bank should take into account, within the model for policy
evaluation, the effects of lagged interest rate variations on potential output. On the other
hand, if the central bank does not take these causal relationships into account, there will
be real losses in the long term, translated by potential output losses.
The effect of output gaps on potential output contributes to endogenous elimination of
inflation deviations. Under positive demand shocks, for example, the inflationary
process would be partially stopped, by means of a higher potential output in future
periods. If the central bank estimates this channel of transmission, increases in interest
rates will be lower than the increase if central bank does not take endogenous potential
output into consideration. It is not necessary to impose integral reduction of future
inflation through future output contractions because current output gaps will impose
potential output gains ahead. This channel of transmission requires an adjusted
instrument rule for monetary policy under inflation targeting regime.
4.1 New instrument for positive demand shocks

Conventional theory also assumes that potential output is endogenous, but not by the demand side.
Potential output would be determined only by the supply side, or through real factors such as resources
stocks and factors productivity. This perspective is implicit in Kohns (2003) words: assessments of the
level and growth of potential GDP must be revised frequently, and of course these variables are not under
the control of the central bank.
9
Implicitly, equation (6) is inside equation (1).

The central bank adjusts interest rates considering that potential output depends on the
output gap with a two-period lag. Hence, facing positive demand shocks, let instrument
rule be:
(7) rt = z1t + z2 yt k{E[Ypt+2] Ypt} + u2t
Equation (7) is an extension of Taylors traditional rule (equation 3), by including
k{E[Ypt+2] Ypt}, where E[Ypt+2] is the expected t+2 period potential output. This
additional component shows that the central bank is aware of endogenous potential
output from the demand side; u2t is a random control error (stochastic process with zero
mean and constant variance) of this adjusted rule. Given k > 0, monetary authority
becomes thriftier (less aggressive), as the difference between expected future potential
output and current potential output is higher. Now, let the expected t+2 period potential
output be:
(8) E[Ypt+2] = E[Ypt+1] + (Yt - Ypt) = Ypt + (Yt-1 - Ypt-1) + (Yt - Ypt)
Substituting (8) in (7), let instrument rule be under positive demand shocks:
(9) rt = z1t + (z2 k) yt kit + u2t , given it = (Yt-1 - Ypt-1) = yt-1
In equation (9), the adjusted instrument rule presents two basic differences in relation to
Taylors traditional rule (equation 3), facing positive demand shocks:
a) Facing positive demand shocks, with yt raising, the central bank increases
interest rates by a lower magnitude (the central bank is thriftier); this difference
is given as subtracted from z2;
b) Higher net investments in period t, under an economic expansion through the
positive demand shock, lower interest rate chosen by the monetary authority
because higher will be potential output in t+1. Hence, the central bank can make
current monetary policy less tight, allowing effective output to expand in t+1.
Proposition 1: When the central bank is aware of endogenous potential output from the
demand side, and takes it into account in its structural model used to evaluate policy,
interest rate response facing positive demand shocks is less aggressive (more thriftier),
if compared with a response that does not take endogenous productive capacity into
consideration.
Proposition 1 means that the central bank, under positive demand shocks, increases real
interest rates by a lower magnitude, if compared with a central bank that does not
assume endogenous potential output from the demand side in its own model of guiding
policy. The basic effect of such an adjusted instrument response is a higher potential
output in the long term, in addition to price stability, because monetary policy is
minimizing its negative effects on productive capacity formation.
4.2 New instrument for negative demand shocks
Facing negative demand shocks, in their turn, let instrument rule be:
9

(7) rt = z1t + z2 yt + k{E[Ypt+2] Ypt }+ u2t

Equation (7) makes use of + k{E[Ypt+2] Ypt } instead of k{E[Ypt+2] Ypt}, posed in
equation (7). Contrary to what happens with positive demand shocks, negative demand
shocks impose reductions in future potential output through induced lower investments
with a two-period lag. Hence, monetary authority decreases interest rates more
aggressively, under negative output gaps, in comparison with what happens in the case
of a conventional central bank. As is known,
(8) E[Ypt+2] = E[Ypt+1] + (Yt - Ypt) = Ypt + (Yt-1 - Ypt-1) + (Yt - Ypt)
Substituting (8) in (7), let instrument rule be, under negative demand shocks:
(9) rt = z1t + (z2 + k) yt + kit + u2t , given it = (Yt-1 - Ypt-1) = yt-1
In equation (9), the adjusted instrument rule presents two basic differences in relation
to Taylors traditional rule (equation 3), facing negative demand shocks:
c) Facing negative demand shocks, with diminishing yt, the central bank decreases
interest rate in higher magnitude (central bank is more aggressive); this
difference is given by added to z2;
d) Lower net investments in period t, under an economic contraction, lower interest
rate chosen by monetary authority, because potential output will be lower in t+1.
Hence, the central bank lets current monetary policy be loose, allowing effective
output to expand in t+1 and investments and potential output in the long term.
That means a counter-cyclical behavior.
Proposition 2: When the central bank is aware of endogenous potential output from the
demand side, and takes it into account in its structural model used to evaluate policy,
interest rate response facing negative demand shocks is more aggressive (less thriftier),
if compared with a response that does not take endogenous productive capacity into
consideration.
A consequence of Proposition 2 is an aggressive real interest response when the central
bank deals with negative output gaps, as it is known that these negative gaps will reduce
future potential output. The central bank, with such knowledge, does not only seek
decreased real interest rates, but seeks them in greater magnitudes and more quickly. A
summary of instrument rules in both positive and negative shocks, under a conventional
and non-conventional central bank is given below:

Monetary policy conduction under two alternative central banks

10

Case

Conventional central
bank

Positive demand
shock
Negative demand
shock

Non-conventional central
bank
rt = z1t + (z2 k) yt kit + u2t

rt = z1t + z2 yt + u1t

rt = z1t + (z2 + k) yt + kit + u2t

5 Opportunity social cost and the implicit adjusted social loss function
The conventional idea according to which there is no trade-off under demand shocks
may be rejected: the strict response (equation 3) of the monetary policy to demand
shocks pushes down inflation volatility, but it also implies an opportunity social cost
(Cy), translated by what the positive impulse on potential output economy does not earn.
This type of opportunity cost may be estimated through the difference between the
potential output that would be verified under the flexible rule (rule 9 or 9), E[(Ypt)f],
and the potential output that is actually observed under traditional rule (rule 3), (Ypt)s, as
such:
(10) Cyt = {E[(Ypt)f] (Ypt)s}
If there is public concern over this kind of opportunity cost while the central bank is
adjusting its monetary policy instrument, the authority should take into account the
trade-off between lower inflation volatility and higher opportunity social cost, when
facing an attack decision on demand shocks. An adjusted social loss function that
resembles these concerns may be:
(11) Lt = j1(Yt - Ypt)2 + j2 (t - n)2 + j3 (Cyt)2
Equation 11 above shows the case of public concerns with three types of social losses:
output gaps, inflation deviations and opportunity social cost. Hence, the public is not
looking only to minimize output and inflation deviations around their targets, as in the
case of the natural hypothesis, but also to minimize opportunity social cost. For
analytical simplicity, let j1 = j2 = j3 = 1, that is, the public gives the same weight to the
three kinds of potential social losses when the central bank is deciding on interest rate
levels.
6 A small numeric simulation
The simulation aims to show that, under endogenous potential output from the demand
side, the desirable instrument rule facing positive demand shocks 10 becomes more
thriftier (less aggressive), and that traditional Taylors rule imposes social losses
translated by lower potential output levels in the long term.

10

For simplicity, the simulation is run only in the case of positive demand shocks, but it is believed that
another simulation for negative demand shocks would bring results with the same essence or quality.

11

The methodology of simulating follows broadly Balls (1999a) article and Walshs
(2003) thoughts. As said by the latter, since we can vary the parameters of our
theoretical models in ways we cannot vary the characteristics of real economies,
simulation methods allow us to answer a variety of what if questions (Walsh, 2003, p.
67).
The step-by-step in the current simulation was:
I)

There was a simulation of interest rate responses to demand shocks under

exogenous potential output () and consistent with Taylors traditional
rule (equation 3), in order to verify real interest rates levels in line with
conventional central bank;

II)

These last values were applied to an economy subjected to endogenous

potential output () in order to simulate the economic performance
obtained by an orthodox central bank under endogenous potential output
economy;

III)

Equation (9) was applied to an endogenous potential output economy to

verify economic performance along with a non-conventional central bank;

IV)

The results of steps (II) and (III) above were compared.

The values chosen for m en are, respectively, 0.4, 0.8 and 1, these values the same as
those adopted in Ball (1999a), based on empirical evidence. The inflationary inertia
level is unitary (), but the qualitative results in the current analysis would not be
changed if an inertia level lower than 1 were used. The others parameters and initial
condition values were adopted freely. The only concern was to choose values that did
not give hypersensibility to structural relations. Below, all values imposed to the
simulation, including shocks, are listed.

Parameters, initial conditions and shocks

Y*

Yp*

R*

Rn

*
12

700

700

n
4

m
0.8

n
1

0.4

z1
0.5
tYt)
0

z2
1

0 or 0.5

0.2

tYt)
*
0

t+5

t+18

t+20

t+28

20

45

500

35

Given Y*, Yp*, R*, * and tYt)0 initial conditions.

The results were as follows: Under rule 3 (or equation 3), by means of a conventional
central bank, real interest rates achieved a maximum of 2.7 in log, as a consequence of
demand shocks and their effects on inflation rates. Interest rates presented volatility
sum of square deviations around 253,875; on the other hand, the non-conventional
central bank, through rule 9, attained a maximum interest rate of 2.65, after the same
observed demand shocks. In its turn, the interest rate volatility remained at around
208,853, much less than under rule 3. Hence, under potential output from demand side,
rule 9, instead of rule 3, imposes less interest rate volatility and lower maximum levels
of interest rate.
Likewise, under rule 3, simulation shows a maximum potential output of 964.00, while
under rule 9 that measure was 966.00 monetary units (m.u.). Although the difference is
too low, it is obvious that the latter rises as demand shocks rises. Moreover, average
potential output is less under rule 3 if compared with rule 9: the former attains 675.75
monetary units and the latter 707.57.
In its turn, long term potential output presents some kind of trajectory that confirms the
predictions of our hypothesis: when the endogenous output by the demand side operates,
central banks that take it into account within their structural model used to evaluate
policy reache higher long term levels of potential output. This variable reached 662.50
m.u. in the long term when by rule 3, but 700.00 when through rule 9. These worse
results in terms of potential output under a conventional central bank are caused by its
inadequate instrument rule (equation 3), through which interest rates responses and
behavior are not satisfactory.
However, a prima facie analysis may guide to a wrong meaning of these results. The
fact that, through rule 9, long term potential output reaches 700.00 m.u., that is, the
initial potential output value, may be thought as a contradiction in relation to the
proposition according to which The basic effect of such an adjusted instrument
response is a higher potential output in the long term. Nevertheless, this apparent
contradiction is eliminated if we analyze the long term potential output by rule 9 in
comparison with the result attained through rule 3. In other words, if with the rule 9 the

13

long term potential output is not higher than the initial potential output value 11, on the
other hand, with the rule 3, a conventional central bank, the result observed is lower
than the initial potential output level. The Table 1 below presents the synthesis of the
main results in the simulation.
Table 1
Economic performance under rules 3 and 9 in the face of positive demand shocks
Rule (or equation) 3
Rule (or equation) 9
Maximum interest rate
2.7 (log)
2.65 (log)
Interest rate volatility*
253,875
208,853
Maximum potential output
964.00
966.00
Average potential output
675.75
707.57
Long term potential output
662.50
700.00
* Sum of square deviations

The dynamics of both inflation targeting regimes are shown in Graph 1 below, and
correspond to the values discussed above.
Graph 1 - Potential output trajectory under rules 3 and 9

In their turn, what are the impacts on inflation rates from both these different rules of
monetary policy? Simulation shows that central banks following rule 3, operating under
endogenous potential output from the demand side, impose a deflationary trend on the
economic system. That is, as the interest rate rises in a more aggressive way by rule 3,
so the lower potential output trend comes together with lower inflation rates in the long
term: long term inflation rate of about 26% (deflation), much lower than the inflation
target (4%).
It is interesting to note that this deflationary trend is also verified in Khan, King &
Wolmans (2003) optimal policy modeling, albeit they find such a trend along with
11

Note that this equality between long term potential output and the initial potential output value, in the
case of rule 9, does not mean that a correlation between demand shocks and potential output does not
exist. Indeed, the demand shocks impose endogenous fluctuations on potential output, under both
regimes, as may be observed in Graph 1 and by the results in Table 1.

14

desirable real resources allocation, and thus a good or acceptable result. The same does
not occur in our model because it takes into account endogenous potential output by the
demand side. The latter implies calling for an adjusted instrument rule, introducing
expected potential output modification as another important component facing monetary
policy actions. By establishing rule 9 as a policy instrument, the central bank attained a
long term inflation rate equal to the inflation target (4%), and, at the same time, higher
potential output levels in the long term. The inflationary dynamic can be seen in Graph
2 below:
Graph 2 Inflationary dynamic under rules 3 and 9

Moreover, it is important to show that some long term results in the simulation are
sensible to changes in specific structural parameters values; for example, changing ,
the coefficient that measures the sensibility of the potential output to lagged output gaps
(equations 4 and 6), causes variations in the long term potential output under rule 3,
although this variable is not altered when under rule 9, as the simulations have shown.
Graph 3 below presents the long term potential output, under rule 3, as a function of
levels. It is easy to verify that: the higher the level, the lower is the long term potential
output under rule 3, subjected to the same demand shocks and the same other
parameters values in the simulation. It means that the higher the endogeneity of the
potential output from the demand side (measured by ), under demand shocks, the
lower is the potential output an economy attains if the monetary policy is conducted by
the conventional instrument rule (rule 3).
Therefore, the higher the value, the higher the opportunity social cost (equation 10) if
the central bank is conventional, because the difference between the potential output,
observed under rule 3, and the result that would be verified, under rule 9 (700 m.u.),
increases as the potential output value under rule 9 does not change in the face of
variations. As it may be seen from the Graph 3, when varies from 0.01 to 1.2, as a
consequence long term potential output varies approximately from 699.00 to 610.00, if
the demand shocks are attacked by rule 3.
Graph 3 Long term potential output (m.u.) under rule 3 x
15

7 - Conclusions
Conventional inflation targeting models are developed under the natural rate hypothesis.
That is, the reasons for flexibility that are presented by the traditional literature depend
on the hypothesis according to which output gaps have no impact on potential output
over time, and there are no trade-offs when central banks are attacking demand shocks.
This article has introduced the hypothesis of an endogenous potential output from the
demand side in a conventional inflation targeting model in order to evaluate the
implications for monetary policy strategy and instrument rules, particularly when
central banks are attacking demand shocks. Under endogenous potential output by the
demand side, there exists a trade-off between inflation volatility and a kind of
opportunity social cost. In other words, under demand shocks, pushing down inflation
volatility may generate potential output losses in the long term, if the monetary policy
rule does not take into account the appropriate changes.
It has been demonstrated by the numeric simulation that conventional instrument rules,
in the Taylor rule tradition, are associated with worse economic performance if
compared with an adjusted instrument rule which takes endogenous productive capacity
into account. On the other hand, when the central bank calibrates its instrument rule for
endogeneity by the demand side in the potential output, interest rate responses become
more aggressive under negative demand shocks and more thriftier under positive
demand shocks, taking the economic system to higher potential output levels in the long
term if compared with the results obtained by the conventional central bank , along
with the inflation rate equal to the target.
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