Monetary Policy, In‡ation,

and the Business Cycle

Chapter 4.
Monetary Policy Design
in the Basic New Keynesian Model

Jordi Galí
CREI and UPF
August 2007

Correspondence: Centre de Recerca en Economia Internacional (CREI); Ramon Trias

Fargas 25; 08005 Barcelona (Spain). E-mail: jgali@crei.cat
 The present chapter addresses the question of how monetary policy should
be conducted, using as a reference framework the basic new Keynesian model
developed in chapter 3. We start by characterizing that model’s e¢ cient
allocation. The latter is shown to correspond to the equilibrium allocation
of the decentralized economy under monopolistic competition and ‡exible
prices, once an appropriately chosen subsidy is in place. As it will be shown,
when prices are sticky, that allocation can be attained by means of a policy
that fully stabilizes the price level.
After determining the objectives of the optimal monetary policy, we turn
to issues pertaining to its implementation. We provide examples of interest
rules that implement the optimal policy, i.e. optimal interest rate rules. But
we also argue that none of those rules seems a likely candidate to guide mon-
etary policy in practice, for they all require that the central bank responds
contemporaneously to changes in a variable–the natural rate of interest–
which is not observable in actual economies. That observation motivates the
introduction of rules that a central bank could arguably follow in practice
(which we label as "simple rules"), and the development of a criterion to
evaluate the relative desirability of those rules, based on their implied wel-
fare losses. We provide an illustration of that approach to policy evaluation
by analyzing the properties of two such simple rules: a Taylor rule and a
constant money growth rule.

1 The E¢ cient Allocation

The e¢ cient allocation associated with the model economy described in chap-
ter 3 can be determined by solving the problem facing a benevolent social
planner seeking to maximize the representative household’s welfare, given
technology and preferences. Thus, each period the optimal allocation must
maximize the household’s utility
U (Ct ; Nt )
R1 1 1
where Ct 0
Ct (i)1 di subject to the resource constraints

Ct (i) = At Nt (i)1
for all i 2 [0; 1] and Z 1
Nt = Nt (i) di
0

1
 The associated optimality conditions are

Ct (i) = Ct , all i 2 [0; 1] (1)

Nt (i) = Nt , all i 2 [0; 1] (2)

Un;t
= M P Nt (3)
Uc;t
where M P Nt (1 ) At Nt denotes the economy’s average marginal
product of labor (which in the case of the symmetric allocation considered
above, also happens to coincide with the marginal product for each individual
…rm).
Thus we see that it is optimal to produce and consume the same quantity
of all goods, and to allocate the same amount of labor to all …rms. That result
is a consequence of all goods entering the utility function symmetrically,
combined with concavity of utility and identical technologies to produce all
goods. Once that symmetric allocation is imposed, the remaining condition
de…ning the e¢ cient allocation (equation (3)), equates the marginal rate
of substitution between consumption and work hours to the corresponding
marginal rate of transformation (which in turn corresponds to the marginal
product of labor). Note also that the latter condition coincides with the one
determining the equilibrium allocation of the classical monetary model (with
perfect competition and fully ‡exible prices) analyzed in chapter 2.
Next we discuss the factors that make the equilibrium allocation in our
baseline model suboptimal.

2 Sources of Suboptimality in the Basic New

Keynesian Model
The basic new Keynesian model developed in chapter 3 is characterized by
two distortions, whose implications are worth considering separately. The
…rst distortion is the presence of market power in goods markets, exercised
by monopolistically competitive …rms. That distortion is unrelated to the
presence of sticky prices, i.e. it would be e¤ective even under the assump-
tion of ‡exible prices. The second distortion results from our assumption
of infrequent adjustment of prices by …rms. Next we discuss both types of
distortions and their implications for the e¢ ciency of equilibrium allocations.

2
2.1 Distortions Unrelated to Sticky Prices: Monopo-
listic Competition
The fact the each …rm perceives the demand for its di¤erentiated product to
be imperfectly-elastic endows it with some market power and leads to pricing-
above-marginal cost policies. To isolate the role of monopolistic competition
let us suppose for the time being that prices are fully ‡exible, i.e. each …rm
can adjust freely the price of its good each period. In that case, and under
our assumptions, the pro…t maximizing price is identical across …rms. In
particular, under an isoelastic demand function (with price-elasticity ), that
optimal price-setting rule is given by:
Wt
Pt = M
M P Nt
Wt
where M 1
> 1 is the (gross) optimal markup chosen by …rms and M P Nt
is the marginal cost. Accordingly,
Un;t Wt M P Nt
= = < M P Nt
Uc;t Pt M
where the …rst equality follows from the optimality conditions of the house-
hold. Hence, we see that the presence of a non-trivial price markup implies
that condition (3) characterizing the e¢ cient allocation is violated. Since,
in equilibrium, the marginal rate of substitution, Un;t =Uc;t , and the mar-
ginal product of labor are, respectively, increasing and decreasing (or non-
increasing) in hours, the presence of a markup distortion leads to an ine¢ -
ciently low level of employment and output.
The above ine¢ ciency resulting from the presence of market power can be
eliminated through the suitable choice of an employment subsidy. Let de-
note the rate at which the cost of employment is subsidized, and assume that
the outlays associated with the subsidy are …nanced by means of lump-sum
taxes. Then, under ‡exible prices, we have Pt = M (1M P )W
Nt
t
. Accordingly,
Un;t Wt M P Nt
= =
Uc;t Pt M(1 )
Hence, the optimal allocation can be attained if M(1 ) = 1 or, equiv-
alently, by setting = 1 . In much of the analysis below we assume that
such an optimal subsidy is in place. By construction, the equilibrium under
‡exible prices is e¢ cient in that case.

3
2.2 Distortions Associated with the Presence of Stag-
gered Price Setting
The assumed constraints on the frequency of price adjustment constitute a
source of ine¢ ciency on two di¤erent grounds. First, the fact that …rms
do not adjust their prices continuously implies that the economy’s average
markup will vary over time in response to shocks, and will generally di¤er
from the constant frictionless markup M. Formally, and denoting the econ-
omy’s average markup as Mt (de…ned as the ratio of average price to average
marginal cost), we have:
Pt Pt M
Mt = =
(1 )(Wt =M P Nt ) Wt =M P Nt
where the second equality follows from the assumption that the subsidy in
place exactly o¤sets the monopolistic competition distortion, which allows
us to isolate the role of sticky prices. In that case we have
Un;t Wt M
= = M P Nt
Uc;t Pt Mt
which violates e¢ ciency condition (3) to the extent that Mt 6= M. The
e¢ ciency of the equilibrium allocation can only be restored if policy manages
to stabilize the economy’s average markup at its frictionless level.
In addition to the above ine¢ ciency, which implies either too low or too
high a level of aggregate employment and output, the presence of staggered
price setting is a source of a second type of ine¢ ciency. The latter has to
do with the fact that the relative prices of di¤erent goods will vary in a
way unwarranted by changes in preferences or technologies, as a result of
the lack of synchronization in price adjustments. Thus, we will generally
have Pt (i) 6= Pt (j) for any pair of goods (i; j) whose prices do not happen to
have been adjusted in the same period. Such relative price distortions will
lead, in turn, to di¤erent quantities of the di¤erent goods being produced
and consumed, i.e. Ct (i) 6= Ct (j); and, as a result, Nt (i) 6= Nt (j) for some
(i; j). That outcome violates e¢ ciency conditions (1) and (2). Attaining the
e¢ ciency allocation requires that the quantities produced and consumed of
all goods are equalized (and, hence, that so are their prices and marginal
costs). Accordingly, markups should be identical across …rms and goods at
all times, in addition to being constant (and equal to the frictionless markup)
on average.

4
 Next we characterize the policy that will attain those objectives.

3 Optimal Monetary Policy in the Basic New

Keynesian Model
In addition to assuming an optimal subsidy in place that exactly o¤sets the
market power distortion, and in order to keep the analysis simple, we restrict
ourselves to the case in which there are no inherited relative price distortions,
i.e. we assume that P 1 (i) = P 1 for all i 2 [0; 1].1 Under those assumptions,
the e¢ cient allocation can be attained by a policy that stabilizes marginal
costs at a level consistent with …rms’ desired markup, given the prices in
place. If that policy is expected to be in place inde…nitely, no …rm has an
incentive to adjust its price, since it is currently charging its optimal markup
and expects to keep doing so in the future without having to change its price.
As a result, Pt = Pt 1 and, hence, Pt = Pt 1 for t = 0; 1; 2; ::: In other words,
the aggregate price level is fully stabilized and no relative price distortions
emerge. In addition, Mt = M for all t, and output and employment match
their counterparts in the ‡exible price equilibrium allocation (which, in turn,
corresponds to the e¢ cient allocation, given the subsidy in place)
Using the notation for the log-linearized model introduced in the previous
chapter, the optimal policy requires that for all t,

yet = 0

t =0
i.e., the output gap is closed at all times, which (as implied by the new
Keynesian Phillips curve) leads to zero in‡ation. The dynamic IS equation
then implies

it = rtn
for all t, i.e. the equilibrium nominal interest rate (which equals the real
rate, given zero in‡ation) must be equal to the natural interest rate.
1
The case of a non-degenerate initial distribution of prices is analyzed in Yun (2005).
In the latter case the optimal monetary policy converges to the one described here after a
transition period.

5
 Two features of the optimal policy are worth emphasizing. First, stabi-
lizing output is not desirable in itself. Instead, output should vary one for
one with the natural level of output, i.e. yt = ytn for all t. There is no reason,
in principle, why the natural level of output should be constant or follow a
smooth trend, since all kinds of real shocks will be a source of variations in
its level. In that context, policies that stress output stability (possibly about
a smooth trend) may generate potentially large deviations of output from its
natural level and, thus, be suboptimal. This point is illustrated in section 4
below, in the context of a quantitative analysis of a simple policy rule.
Secondly, price stability emerges as a feature of the optimal policy even
though, a priori, the policymaker does not attach any weight to such an
objective. Instead, price stability is closely associated with the attainment
of the e¢ cient allocation (which is a more immediate policy objective). But
the only way to replicate the (e¢ cient) ‡exible price allocation when prices
are sticky is by making all …rms happy with their existing prices, so that the
assumed constraints on the adjustment of those prices are e¤ectively non-
binding. Aggregate price stability then follows as a consequence of no …rm
willing to adjust its price.

3.1 Implementation: Optimal Interest Rate Rules

Next we consider some candidate rules for implementing the optimal policy.
All of them are consistent with the desired equilibrium outcome. Some,
however, are also consistent with other suboptimal outcomes. In all cases,
and in order to analyze its equilibrium implications, we embed the candidate
rule considered in the two equations describing the non-policy block of the
basic new Keynesian model introduced in chapter 3. Those two key equations
are shown here again for convenience:
1
yet = Et fe
yt+1 g (it Et f t+1 g rtn ) (4)

t = Et f t+1 g + yet (5)

3.1.1 An Exogenous Interest Rate Rule

Consider the candidate interest rate rule

it = rtn (6)

6
for all t . This is a rule that instructs the central bank to adjust the nominal
rate one for one with variations in the natural rate (and only in response
to variations in the latter). Such a rule would seem a natural candidate
to implement the optimal policy since (6) was shown earlier to be always
satis…ed in an equilibrium that attains the optimal allocation.
Substituting (6) into (4) and rearranging terms we can represent the
equilibrium conditions under rule (6) by means of the system:

yet Et fe
yt+1 g
= AO (7)
t Et f t+1 g
where
1
1
AO
+
Note that yet = t = 0 for all t –the outcome associated with the optimal
policy–is a solution to (7). That solution, however, is not unique: it can be
shown that one of the two (real) eigenvalues of AO always lies in the interval
(0; 1), while the second is strictly greater than unity. Given that both yet
and t are non-predetermined, the existence of an eigenvalue outside the
unit circle implies the the existence of a multiplicity of equilibria in addition
to yet = t = 0 for all t.2 In that case nothing guarantees that the latter
allocation will be precisely the one that will emerge as an equilibrium. That
shortcoming leads us to consider alternative rules to (6).

3.1.2 An Interest Rate Rule with an Endogenous Component

Let us consider next the following interest rate rule

it = rtn + t + y yet (8)

where and y are non-negative coe¢ cients determined by the central bank,
and describing the strength of the interest rate response to deviations of
in‡ation or the output gap from their target levels.
As above, we can substitute the nominal rate out using the assumed
interest rate rule, and represent the equilibrium dynamics by means of a
system of di¤erence equations of the form
2
See, e.g. Blanchard and Kahn (1980).

7
 yet Et fe
yt+1 g
= AT (9)
t Et f t+1 g
where

1
AT
+ ( + y)
1
and + y+
.
Once again, the desired outcome (eyt = t = 0 for all t) is always a solution
to the dynamical system (9) and, hence, an equilibrium of the economy
under rule (8). Yet, in order for that outcome to be the only (stationary)
equilibrium both eigenvalues of matrix AT should lie within the unit circle.
The size of those eigenvalues now depends on the policy coe¢ cients ( ; y ),
in addition to the non-policy parameters. If we restrict ourselves to non-
negative values for ( ; y ), a necessary and su¢ cient condition for AT to
have two eigenvalues within the unit circle and, hence, for the equilibrium to
be unique, is given by3

( 1) + (1 ) y >0 (10)
that is (and roughly speaking): the monetary authority should respond to
deviations of in‡ation and the output gap from their target levels by adjusting
the nominal rate with "su¢ cient strength." Figure 4.1 illustrates graphically
the regions of parameter space for ( ; y ) associated with determinate and
indeterminate equilibria, as implied by condition (10).
Interestingly, and somewhat paradoxically, if condition (10) is satis…ed,
both the output gap and in‡ation will be zero and, hence, it = rtn for all t will
hold ex-post. Thus, and in contrast with the case considered above (in which
the equilibrium outcome it = rtn was also taken to be the policy rule), it is
the presence of a "threat" of a strong response by the monetary authority
to an eventual deviation of the output gap and in‡ation from target that
su¢ ces to rule out any such deviation in equilibrium.
Some economic intuition for the form of condition (10) can be obtained
by considering the eventual implications of rule (8) for the nominal rate,
were a permanent increase in in‡ation of size d to occur (and assuming no
permanent changes in the natural rate):
3
See Bullard and Mitra (2002) for a proof.

8
 di = d + ydey
y (1 )
= + d (11)

where the second equality makes use of the long-term relationship between
in‡ation and the output gap implied by (5). Note that condition (10) is
equivalent to the term in brackets in (11) being greater than one. Thus,
the equilibrium will be unique under interest rate rule (8) whenever and
y are su¢ ciently large to guarantee that the real rate eventually rises in
the face of an increase in in‡ation (thus tending to counteract that increase
and acting as a stabilizing force). The previous property is often referred to
as the Taylor principle and, to the extent that it prevents the emergence of
multiple equilibria, it is naturally viewed as a desirable feature of any interest
rate rule.4

3.1.3 A Forward-Looking Interest Rate Rule

In order to illustrate the existence of a multiplicity of policy rules capable
of implementing the optimal policy, let us consider the following forward-
looking rule
it = rtn + Et f t+1 g + y Et fe
yt+1 g (12)
which has the monetary authority adjust the nominal rate in response to
variations in expected in‡ation and the expected output gap (as opposed to
their current values, as assumed in (8)).
Under (12) the implied dynamics are described by the system

yet Et fe
yt+1 g
= AF
t Et f t+1 g

where
1 1
1 y
AF 1 1
(1 y)

4
See Woodford (2000) for a discussion.

9
 In this case the conditions for a unique equilibrium (i.e. for both eigen-
values of AF lying within the unit circle) are twofold and given by5

( 1) + (1 ) y > 0 (13)
( 1) + (1 + ) y < 2 (1 + ) (14)

Figure 4.2 represents the determinacy/indeterminacy regions in ( ; y )

space, under the baseline calibration for the remaining parameters. Note
that in contrast with the "contemporaneous" rule considered in the previous
subsection, determinacy of equilibrium under the present forward-looking
rule requires that the central bank reacts neither "too strongly" nor "too
weakly" to deviations of in‡ation and/or the output gap from target. Yet,
the …gure suggests that the kind of overreaction that would be conducive to
indeterminacy would require rather extreme values of the in‡ation and/or
output gap coe¢ cients, well above those characterizing empirical interest
rate rules.

3.2 Practical Shortcomings of Optimal Policy Rules

In the previous subsection we have provided two examples of interest rate
rules that implement the optimal policy, thus guaranteeing that the e¢ cient
allocation is attained as the unique equilibrium outcome. While such optimal
interest rate rules appear to take a relatively simple form, there exists an
important reason why they are unlikely to provide useful practical guidance
for the conduct of monetary policy. The reason is that they both require that
the policy rate is adjusted one-for-one with the natural rate of interest, thus
implicitly assuming observability of the latter variable. That assumption is
plainly unrealistic since determination of the natural rate and its movements
requires an exact knowledge of (i) the economy’s "true model," (ii) the values
taken by all its parameters, and (iii) the realized value (observed in real time)
of all the shocks impinging on the economy.
Note that a similar requirement would have to be met if, as implied by (8)
and (12), the central bank should also adjust the nominal rate in response
to deviations of output from the natural level of output, since the latter is
also unobservable. That requirement, however, is not nearly as binding as the
5
Bullard and Mitra (2002) list a third condition, given by the inequality y < (1 +
1
), as necessary for uniqueness. But it can be easily checked that the latter condition
is implied by the two conditions (13) and (14).

10
unobservability of the natural rate of interest, for nothing prevents the central
bank from implementing the optimal policy by means of a rule that does not
require a systematic response to changes in the output gap. Formally, y in
(8) or (12) could be set to zero, with uniqueness of equilibrium being still
guaranteed by the choice of an in‡ation coe¢ cient greater than unity (and
no greater than 1 + 2 (1 + ) 1 in the case of the forward-looking rule).
The practical shortcomings of optimal interest rate rules discussed above
have led many authors to propose a variety of "simple rules"–understood as
rules that a central bank could arguably adopt in practice–and to analyze
their properties.6 In that context, an interest rate rule is generally considered
"simple" if it makes the policy instrument a function of observable variables
only, and does not require any precise knowledge of the exact model or the
values taken by its parameters. The desirability of any given simple rule is
thus given to a large extent by its robustness, i.e. its ability to yield a good
performance across di¤erent models and parameter con…gurations.
In the following section we analyze two such simple rules –a simple Taylor-
type rule, and a constant money growth rule–and assess their performance
in the context of our baseline new Keynesian model.

4 Two Simple Monetary Policy Rules

In this section we provide an illustration of how the basic new Keynesian
model developed in the previous chapter can be used to assess the perfor-
mance of two policy rules. A formal evaluation of the performance of a simple
rule (relative, say, to the optimal rule or to an alternative simple rule) re-
quires the use of some quantitative criterion. Following the seminal work
of Rotemberg and Woodford (1999) much of the literature has adopted a
welfare-based criterion, relying on a second-order approximation to the util-
ity losses experienced by the representative consumer as a consequence of
deviations from the e¢ cient allocation. As shown in the appendix, under
the assumptions made in the present chapter (which guarantee the optimal-
ity of the ‡exible price equilibrium), that approximation yields the following
6
The volume edited by John Taylor (1999) contains several important contributions in
that regard.

11
welfare loss function

1 X 1
'+
t
W = E0 + yet2 + 2
t
2 t=0
1

where welfare losses are expressed in terms of the equivalent permanent con-
sumption decline, measured as a fraction of steady state consumption.
The average welfare loss per period is thus given by the following linear
combination of the variances of the output gap and in‡ation
1 '+
L= + var(e
yt ) + var( t )
2 1
Note that the relative weight of output gap ‡uctuations in the loss func-
tion is increasing in , ' and . The reason is that larger values of those
"curvature" parameters amplify the e¤ect of any given deviation of output
from its natural level on the size of the gap between the marginal rate of
substitution and the marginal product of labor, which is a measure of the
economy’s aggregate ine¢ ciency. On the other hand, the weight of in‡ation
‡uctuations is increasing in the elasticity of substitution among goods –since
the latter ampli…es the welfare losses caused by any given price dispersion–
and the degree of price stickiness (which is inversely related to ), which
ampli…es the degree of price dispersion resulting from any given deviation
from zero in‡ation.
Given a policy rule and a calibration of the model’s parameters, one
can determine the implied variance of in‡ation and the output gap and the
corresponding welfare losses associated with that rule (relative to the optimal
allocation). That procedure is illustrated next through the analysis of two
simple rules.

4.1 A Taylor-type Interest Rate Rule

Let us …rst consider the following interest rule, in the spirit of Taylor (1993)

it = + t + y ybt (15)

where ybt log(Yt =Y ) denotes the log deviation of output from its steady
state and where > 0 and y > 0 are assumed to satisfy the determinacy
condition (10). Again, the choice of intercept log is consistent with
a zero in‡ation steady state.

12
 Note that we can rewrite (15) in terms of the output gap as

it = + t + y yet + vt (16)

where vt btn . The resulting equilibrium dynamics are thus identical to

y y
those of the interest rate rule analyzed in chapter 3, with vt now re-interpreted
as a driving force proportional to the deviations of natural output from steady
state, instead of an exogenous monetary policy shock. Note that the variance
of the "shock" vt is no longer exogenous, but increasing in y , the coe¢ cient
determining the response of the monetary authority to ‡uctuations in output.
Formally, the equilibrium dynamics are described by the system

yet Et fe
yt+1 g
= AT rtn
+ BT (b vt )
t Et f t+1 g
where AT and BT are de…ned as in chapter 3. Assuming that variations in the
technology parameter at represent the only driving force in the economy, and
are described by a stationary AR(1) process with autoregressive coe¢ cient
a , we have:

n n
rbtn vt = ya (1 a) at y ya at
n
= ya [ (1 a) + y] at
1+'
where, as in chapter 3, nya +'+ (1 )
> 0. From the analysis in the
previous chapter, we know that the variance of the output gap and in‡ation
under a rule of the form (16) is proportional to that of BT (b rtn vt ), which
is strictly increasing in y . Hence, a policy seeking to stabilize output by
responding aggressively to deviations in that variable from steady state (or
trend) is bound to lower the representative consumer’s utility, by increasing
the variance of the output gap and in‡ation.7
The left panel of Table 4.1 displays some statistics for four di¤erent cali-
brations of rule (15), corresponding to alternative con…gurations for and
y . The …rst column corresponds to the calibration proposed by Taylor
(1993) as a good approximation to the interest rate policy of the Fed during
7
Notice that in this simple example the optimal allocation can be attained by setting
y = (1 a ). In that case, our simple rule is equivalent to the optimal rule it =
rtn + t .

13
the Greenspan years.8 The second and third rules assume no response to out-
put ‡uctuations, and with a very aggressive anti-in‡ation stance in the case
of the third rule ( = 5). Finally, the fourth rule assumes a strong output-
stabilization motive ( y = 1). The remaining parameters are calibrated at
their baseline values, as introduced in the previous chapter.
For each version of the Taylor rule, Table 4.1 shows the implied standard
deviations of the output gap and (annualized) in‡ation, both expressed in
percent terms, as well as the welfare losses resulting from the associated
deviations from the e¢ cient allocation, expressed as a fraction of steady
state consumption. Several results stand out. First, in a way consistent with
the analysis above, versions of the rule that involve a systematic response to
output variations generate larger ‡uctuations in the output gap and in‡ation
and, hence, larger welfare losses. Those losses are moderate (0.3 percent
of steady state consumption) under Taylor’s original calibration, but they
become substantial (close to 2 percent of steady state consumption) when
the output coe¢ cient y is set to unity. Secondly, the smallest welfare losses
are attained when the monetary authority responds to changes in in‡ation
only. Furthermore, those losses (as well as the underlying ‡uctuations in the
output gap and in‡ation) become smaller as the strength of that response
increases. Hence, and at least in the context of the basic new Keynesian
model considered here, a simple Taylor-type rule that responds aggressively
to movements in in‡ation can approximate arbitrarily well the optimal policy.

4.2 A Constant Money Growth Rule

Next we consider a simple rule consisting of a constant growth rate for the
money supply, a rule generally associated with Friedman (1960). Without
loss of generality, we assume a zero rate of growth of the money supply,
which is consistent with zero in‡ation in the steady state (given the absence
of secular growth). Formally,

mt = 0

for all t.
8
Taylor’s proposed coe¢ cient values were 1.5 for in‡ation and 0.5 for output, based
on a speci…cation with annualized in‡ation and interest rates. Our choice of y = 0:5=4
is consistent with Taylor’s proposed calibration since both it and t in our model are
expressed in quarterly rates.

14
 Once again, the assumption of a monetary rule requires that equilibrium
conditions (4) and (5) be supplemented with a money market clearing con-
dition. Here we take the latter to be of the form

lt = yt it t

where lt mt pt denotes (log) real balances, and t is an exogenous money

demand shock following the process

t = t 1 + "t

It is convenient to rewrite the money market equilibrium condition in

terms of deviations from steady state as follows:
b
lt = yet + ybtn bit t

Letting lt+ lt + t denote (log) real balances adjusted by the exogenous

component of money demand, we have

bit = 1 (e
yt + ybtn b
lt+ )

In addition, using the de…nition of lt+ together with the assumed rule
mt = 0, we have
b
lt+ 1 = b
lt+ + t t

Combining the previous two equations with (4) and (5) to substitute out
the nominal rate, the equilibrium dynamics under a constant money growth
rule can be summarized by the system
2 3 2 3 2 n 3
yet Et fe
yt+1 g rbt
AM;0 4 t 5 = AM;1 4 5
Et f t+1 g + BM 4 ybtn 5
b
lt+ 1 b
lt+ t

where AM;0 , AM;1 and BM are de…ned as in the previous chapter.

The right hand panel of Table 4.1 reports the standard deviation of the
output gap and in‡ation, as well as the implied welfare losses, under a con-
stant money growth rule. Two cases are considered, depending on whether
money demand is assumed to be subject or not to exogenous disturbances.
In both cases the natural output and the natural rate of interest vary in
response to technology shocks (according to the baseline calibration of the

15
latter introduced in the previous chapter). When money demand shocks are
allowed for, the corresponding process for is calibrated by estimating an
AR(1) process for the (…rst-di¤erenced) residual of a money demand function
for the period 1989:I-2004:IV-a period characterized by substantial instabil-
ity in the demand for money–computed using an interest rate-semielasticity
= 4 (see discussion in the previous chapter). The estimated standard devi-
ation for the residual of the AR(1) process is = 0:0063 while the estimated
AR(1) coe¢ cient is = 0:6.
Notice that in the absence of money demand shocks, a constant money
growth rule delivers a performance comparable, in terms of welfare losses, to
a Taylor rule with coe¢ cients = 1:5 and y = 0. Yet, when the calibrated
money demand shock is introduced the performance of a constant money
growth rule deteriorates considerably, with the volatility of both the output
gap and in‡ation rising to a level associated with welfare losses above those
of the baseline Taylor rule. Thus, and not surprisingly, the degree of stability
of money demand is a key element in determining the desirability of a rule
that focuses on the control of a monetary aggregate.

5 Notes on the Literature

An early detailed discussion of the case for price stability in the basic new
Keynesian model can be found in Goodfriend and King (1997). Svensson
(1997) contains an analysis of the desirability of in‡ation targeting strategies,
using a not-fully-microfounded model.
When deriving the optimal policy we have assumed no inherited disper-
sion of prices across …rms. A rigorous analysis of the optimal monetary policy
in the case of an initial non-degenerate price distribution can be found in Yun
(2005).
Taylor (1993) introduced the simple formula commonly known as the
Taylor rule, as providing a good approximation to Fed policy in the early
Greenspan years. Judd and Rudebusch (1998) and Clarida, Galí, and Gertler
(2000) estimate alternative versions of the Taylor rule, and examined its
(in)stability over the postwar period. Taylor (1999) uses the rule calibrated
for the Greenspan years as a benchmark for the evaluation of monetary policy
during other episodes over the postwar period. Orphanides (2003) argues
that the bulk of the deviations from the baseline Taylor rule observed in the
pre-Volcker era may have been the result of large biases in real time measures

16
of the output gap.
Key contributions to the literature on the properties of alternative simple
rules can be found in the papers contained in the volume edited by Taylor
(1999). In particular, the paper by Rotemberg and Woodford (1999) derives
a second order approximation to the utility of the representative consumer.
Chapter 6 in Woodford (2003) provides a detailed discussion of welfare-based
evaluations of policy rules.

17
 Appendix. A Second Order Approximation to Household’s
Welfare: the Case of an Undistorted Steady State
In the present appendix we derive a second order approximation to the
utility of the representative consumer when the economy remains in a neigh-
borhood of an e¢ cient steady state, in a way consistent with the assumptions
made in the present chapter. The generalization to the case of a distorted
steady state is left for chapter 5.
We start by deriving a second order approximation of utility around a
given steady state allocation. Below we make frequent use of the following
second order approximation of relative deviations in terms of log deviations:
Zt Z 1 2
' zbt + zb
Z 2 t
where zbt zt z is the log deviation from steady state for a generic variable
zt . All along we assume that utility is separable in consumption and hours
(i.e., Ucn = 0 ). In order to lighten the notation we de…ne Ut U (Ct ; Nt ),
n n n
Ut U (Ct ; Nt ), and U U (C; N ).
The second order Taylor expansion of Ut around a steady state (C; N )
yields

2 2
Ct C Nt N 1 Ct C 1 Nt N
Ut U ' Uc C +Un N + Ucc C 2 + Unn N 2
C N 2 C 2 N

In terms of log deviations,

1 1+' 2
Ut U ' Uc C ybt + ybt2 + Un N bt +
n bt
n
2 2
Ucc
where Uc
C and ' UUnn n
N , and where we have made use of the market
clearing condition b ct = ybt .
The next step consists in rewriting n bt in terms of output. Using the fact
1
1
R 1 Pt (i) 1
that Nt = AYtt 0 Pt
di , we have

(1 bt = ybt
)n at + dt
R1 1
where dt (1 ) log 0 PPt (i)
t
di: The following lemma shows that dt
is proportional to the cross-sectional variance of relative prices.

18
 Lemma 1: in a neighborhood of a symmetric steady state, and up to a
second order approximation, we have dt = 2 vari fpt (i)g .
Proof: Let pbt (i) pt (i) pt . Notice that,

1
Pt (i)
= exp [(1 ) pbt (i)]
Pt
(1 )2
= 1 + (1 ) pbt (i) + pbt (i)2
2
R1 Pt (i)
1
Note that from the de…nition of Pt , we have 1 = 0 Pt
di. A second
order approximation to this expression thus implies
( 1)
Ei fb
pt (i)g = pt (i)2 g
Ei fb
2
Pt (i) 1
In addition, a second order approximation to Pt
yields:

2
Pt (i) 1 1
=1 pbt (i) + pbt (i)2
Pt 1 2 1

Combining the two previous results, it follows that

Z 1
Pt (i) 1 1 1
di = 1 + pt (i)2 g
Ei fb
0 Pt 2 1
1 1
= 1+ vari fpt (i)g
2 1
1
1 +
, and where the last equality follows from the observation that,
up to second order,
Z 1 Z 1
2
(pt (i) pt ) di ' (pt (i) Ei fpt (i)g)2 di
0 0
vari fpt (i)g

Finally, using the de…nition of dt and up to a second order approximation

we have

19
 Z 1
Pt (i) 1
dt (1 ) log di ' vari fpt (i)g
0 Pt 2

QED.

Now we can rewrite period t utility as:

1 Un N 1+'
Ut U = Uc C ybt + ybt2 + ybt + vari fpt (i)g + (b
yt at )2 +t:i:p:
2 1 2 2(1 )

where t:i:p: stands for "terms independent of policy".

E¢ ciency of the steady state implies UUnc = M P N . Thus, and using the
fact that M P N = (1 )(Y =N ) and Y = C we can write

Ut U 1 1+'
' vari fpt (i)g (1 ) ybt2 + (b
yt at )2 + t:i:p:
Uc C 2 1
1 '+ 1+'
= vari fpt (i)g + + ybt2 2 ybt at + t:i:p:
2 1 1
1 '+
= vari fpt (i)g + + yt2
(b yt ybtn ) + t:i:p:
2b
2 1
1 '+
= vari fpt (i)g + + yet2 + t:i:p:
2 1

where ybtn ytn y n , and where we have used the fact that ybtn = (1 1+'
)+'+
at
n
.and ybt ybt = yet .
Accordingly, we can write a second order approximation to the consumer’s
welfare losses, expressed as a fraction of steady state consumption (and up
to additive terms independent of policy) as:

X
1
Ut U
t
W = E0
t=0
Uc C
1 X 1
'+
t
= E0 vari fpt (i)g + + yet2
2 t=0
1

20
 The …nal step consists in rewriting the terms involving the price dispersion
variable as a function of in‡ation. In order to do so we make use of the
following lemma
P1 t P
Lemma 2: t=0 vari fpt (i)g = (1 )(1 ) 1 t=0
t 2
t
Proof: Woodford (2003, chapter 6)
(1 )(1 )
Using the fact that we can combine the previous lemma
with the expression for the welfare losses above to obtain

1 X1
'+
t 2
W= E0 t + + yet2
2 t=0
1

21
 References
Bullard, James, and Kaushik Mitra (2002): “Learning About Monetary
Policy Rules,”Journal of Monetary Economics, vol. 49, no. 6, 1105-1130.
Clarida, Richard, Jordi Galí, and Mark Gertler (2000): “Monetary Policy
Rules and Macroeconomic Stability: Evidence and Some Theory,”Quarterly
Journal of Economics, vol. 105, issue 1, 147-180.
Friedman, Milton (1960): A Program for Monetary Stability, New York,
Fordham University Press.
Galí, Jordi (2003): “New Perspectives on Monetary Policy, In‡ation, and
the Business Cycle,” in Advances in Economics and Econometrics, volume
III, edited by M. Dewatripont, L. Hansen, and S. Turnovsky, Cambridge
University Press (NBER WP #8767).
Goodfriend, Marvin and Robert G. King (1997): “The New Neoclassical
Synthesis,”NBER Macroeconomics Annual 1997 :
Judd, John P., and Glenn Rudebusch (1998): “Taylor’s Rule and the Fed:
A Tale of Three Chairmen,”FRBSF Economic Review, no. 3, 3-16..
Orphanides, Athanasios (2003): “The Quest for Prosperity Without In-
‡ation,”Journal of Monetary Economics 50, no. 3, 633-663.
Rotemberg, Julio and Michael Woodford (1999): “Interest Rate Rules
in an Estimated Sticky Price Model,” in J.B. Taylor ed., Monetary Policy
Rules, University of Chicago Press.
Svensson, Lars E. O. (1997) “In‡ation Forecast Targeting: Implementing
and Monitoring In‡ation Targets”, European Economic Review 41, June, pp.
1111-47.
Taylor, John B. (1993): “Discretion versus Policy Rules in Practice,”
Carnegie-Rochester Series on Public Policy vol. 39, 195-214.
Taylor, John B. (1999): Monetary Policy Rules, University of Chicago
Press and NBER.
Taylor, John B. (1999): “An Historical Analysis of Monetary Policy
Rules,” in J.B. Taylor ed., Monetary Policy Rules, University of Chicago
Press.
Woodford, Michael (2001): “The Taylor Rule and Optimal Monetary
Policy,”American Economic Review vol. 91, no. 2, 232-237.
Woodford, Michael (2003): Interest and Prices: Foundations of a Theory
of Monetary Policy, Princeton University Press.
Yun, Tack (2005): “Optimal Monetary Policy with Relative Price Distor-
tions”American Economic Review, vol. 95, no. 1, 89-109

22
 Exercises
1. In‡ation Targeting with Noisy Data
Consider a model economy whose output gap and in‡ation dynamics are
described by the system:

t = Et f t+1 g + yet (17)

1
yet = (it Et f t+1 g rtn ) + Et fe
yt+1 g (18)
where all variables are de…ned as in the text. The natural rate rtn is assumed
to follow the exogenous process

rtn = r (rtn 1 ) + "t

where f"t g is a white noise process and r 2 [0; 1):
Suppose that in‡ation is measured with some i.i.d. error t , i.e., ot =
o
t + t where t denotes measured in‡ation. Assume that the central bank
follows the rule

o
it = + t (19)
a) Solve for the equilibrium processes for in‡ation and the output gap
under the rule (19) (hint: you may want to start analyzing the simple case
of r = 0).
b) Describe the behavior of in‡ation, the output gap, and the nominal
rate when approaches in…nity.
c) Determine the size of the in‡ation coe¢ cient that minimizes the vari-
ance of actual in‡ation.

2. Monetary Policy and the E¤ects of Technology Shocks

Consider a new Keynesian economy with equilibrium conditions:
1
yt = Et fyt+1 g (it Et f t+1 g ) (20)

t = Et f t+1 g + (yt ytn ) (21)

where all variables are de…ned as in the text.

23
 Monetary policy is described by a simple rule of the form

it = + t

where > 1. Labor productivity is given by

yt n t = at

where at is an exogenous technology parameter which evolves according to

at = a at 1 + "t

where a 2 [0; 1) and f"t g is an i.i.d. process.

The underlying RBC model is assumed to imply a natural level of output
proportional to technology
ytn = y at
where y > 1.
a) Describe in words where (20) and (21) come from.
b) Determine the equilibrium response of output, employment, and in‡a-
tion to a technology shock. (hint: guess that each endogenous variable will
be proportional to the contemporaneous value of technology).
c) Describe how those responses depend on the value of and . Provide
some intuition. What happens when ! 1? What happens as we change
the degree of price rigidities?
d) Analyze the joint response of employment and output to a technology
shock and discuss brie‡y the implications for our assessment of the role of
technology as a source of business cycles.

3. Interest Rate vs Money Supply Rules

Consider an economy described by the equilibrium conditions:
1
yet = Et fe
yt+1 g (it Et f t+1 g rtn )

t = Et f t+1 g + yet
mt pt = yt it
where all variables are de…ned as in the text. Both ytn and rtn evolve exoge-
nously, independently of monetary policy.

24
 The central bank seeks to minimize a loss function of the form

var(e
yt ) + var( t )

a) Show how the optimal policy could be implemented by means of an

interest rate rule
b) Show that a rule requiring a constant money supply will generally be
suboptimal. Explain. (hint: derive the path of money under the optimal
policy)
c) Derive a money supply rule that would implement the optimal policy.

4. Optimal Monetary Policy with Price-Setting in Advance

Consider an economy where the representative consumer maximizes
X
1
Mt
t
E0 U Ct ; ; Nt
t=0
Pt

subject to a sequence of dynamic budget constraints

Pt Ct + Mt + Qt Bt Mt 1 + Bt 1 + Wt Nt + Tt

and where all variables are de…ned as in the main text.

Assume that period utility is given by:

Mt Mt Nt 1+'
U (Ct ; ; Nt ) = log Ct + log (22)
Pt Pt 1+'
Firms are monopolistically competitive, each producing a di¤erentiated
Pt (i)
good whose demand is given by Yt (i) = Pt
Yt . Each …rm has access to
the linear production function

Yt (i) = At Nt (i) (23)

where productivity evolves according to:

At
= (1 + a) expf"t g
At 1
with f"t g being an i.i.d., normally distributed process with mean 0 and vari-
ance 2" .

25
 The money supply varies exogenously according to the process
Mt
= (1 + m ) expfut g (24)
Mt 1

where fut g is an i.i.d., normally distributed process with mean 0 and variance
2
u.
Finally, we assume that all output is consumed, so that in equilibrium
Yt = Ct for all t.
a) Derive the optimality conditions for the problem facing the represen-
tative consumer.
b) Assume that …rms are monopolistically competitive, each producing
a di¤erentiated good. Each period, after observing the shocks, …rms set the
price of their good in order to maximize current pro…t

Wt
Yt (i) Pt (i)
At

subject to the demand schedule above. Derive the optimality condition as-
sociated with the …rm’s problem.
c) Show that the equilibrium levels of aggregate employment, output, and
in‡ation are given by
1
1 1+'
Nt = 1

Yt = At
t =( m a) + ut "t
d) Discuss how utility depends on the two parameters describing mone-
tary policy, m and 2u (recall that the nominal interest rate is constrained
to be non-negative, i.e., it 0 for all t). Show that the optimal policy must
satisfy the Friedman rule and discuss alternative ways of supporting that rule
in equilibrium.
e) Next let us assume that each period …rms have to set the price in
advance, i.e., before the realization of the shocks. In that case they will
choose a price in order to maximize the discounted pro…t

Wt
Et 1 Qt 1;t Yt (i) Pt (i)
At

26
subject to the demand schedule Yt (i) = PPt (i)
t
Yt , where Qt 1;t Ct 1 Pt 1
Ct Pt
is the stochastic discount factor. Derive the …rst order condition of the …rm’s
problem and solve (exactly) for the equilibrium levels of employment, output
and real balances.
f) Evaluate expected utility at the equilibrium values of output, real bal-
ances and employment:
g) Consider the class of money supply rules of the form (24) such that
ut = " "t + v t , where f t g is a normally distributed i.i.d. process with
zero mean and unit variance, and independent of f"t g at all leads and lags.
Notice that within that family of rules, monetary policy is fully described by
three parameters: m ; " , and v . Determine the values of those parameters
that maximize expected utility, subject to the constraint of a non-negative
nominal interest rate. Show that the resulting equilibrium under the optimal
policy replicates the ‡exible price equilibrium analyzed above.

5. A Price Level Based Interest Rate Rule

Consider an economy described by the equilibrium conditions:

1
yet = Et fe
yt+1 g (it Et f t+1 g rtn )

t = Et f t+1 g + yet
Show that the interest rate rule

it = rtn + p pbt

where pbt pt p , where p is a price level target generates a unique sta-

tionary equilibrium if and only if p > 0.

27
 Table 4.1: Evaluation of Simple Monetary Policy Rules
Taylor Rule Constant Money Growth
1:5 1:5 5 1:5 - -
y 0:125 0 0 1 - -
( ; ) - - - - (0; 0) (0:0063; 0:6)

(e
y) 0:55 0:28 0:04 1:40 1:02 1:62

( ) 2:60 1:33 0:21 6:55 1:25 2:77

welf are loss 0:30 0:08 0:002 1:92 0:08 0:38

28
 Figure 4.1
2.1
2

1.8

1.6
Determinacy

1.4

1.2

φπ
1

0.8

0.6

Indeterminacy
0.4

0.2

0
0 0.2 0.4 0.6 0.8 1 1.2 1.4 1.6 1.8 2
φy
 Figure 4.2

35

30

25

20
Indeterminacy

φπ
15

Determinacy
10

0
0 0.5 1 1.5 2
φy
 Monetary Policy, In‡ation,
and the Business Cycle

Chapter 5.
Monetary Policy Tradeo¤s:
Discretion vs Commitment
Jordi Galí y
CREI and UPF
August 2007

Much of the material in this chapter is based on my paper “The Science of Monetary
Policy: A New Keynesian Perspective,” co-authored with Richard Clarida and Mark
Gertler, and published in the Journal of Economic Literature, 1999.
y
Correspondence: Centre de Recerca en Economia Internacional (CREI), Ramon Trias
Fargas 25; 08005 Barcelona (Spain). E-mail: jordi.gali@upf.edu
1 Monetary Policy Tradeo¤s
In the previous chapter we analyzed the optimal monetary policy problem
in the context of a baseline model in which the presence of staggered price
setting was the only relevant distortion that the central bank had to con-
front. We showed that a policy that seeks to replicate the ‡exible price
equilibrium allocation is both feasible and optimal in that context. That
policy requires that the central bank responds to shocks so that the price
level is fully stabilized. The rationale for such a policy is easy to summarize:
with zero in‡ation, output equals its natural level which in turn, under the
assumptions made in chapter 4, is also the e¢ cient level. Thus, in the en-
vironment analyzed in the previous chapter, the central bank does not face
a meaningful policy tradeo¤, and "strict in‡ation targeting" emerges as the
optimal policy.
We view the analysis of such an environment and its implications for
the design of monetary policy as useful from a pedagogical point of view,
but not as a realistic one. The reason is that, in practice, central banks
view themselves as facing signi…cant tradeo¤s, at least in the short run.
As a result, even central banks that call themselves "in‡ation targeters" do
not claim to be seeking to stabilize in‡ation completely in the short run,
independently of the consequences that this would entail for the evolution
of real variables like output and employment. Instead, the presence of short
run tradeo¤s have led in‡ation targeting central banks to pursue a policy
that allows for a partial accomodation of in‡ationary pressures in the short
run, in order to avoid too large instability of output and employment, while
remaining committed to a medium term in‡ation target. A policy of that
kind is often referred to in the literature as "‡exible in‡ation targeting."1
In the present chapter we introduce a policy tradeo¤, which we model
in a simple fashion, and revisit the problem of optimal monetary policy.
As shown below, the existence of such a policy tradeo¤, combined with the
forward-looking nature of in‡ation, makes it desirable for the central bank to
be able to commit to a state-contingent policy plan (as opposed to pursuing
a policy characterized by sequential, or period-by-period optimization).
1
The term ‡exible in‡ation targeting was coined by Lars Svensson, to refer to the
kind of optimal monetary policies that result from the minimization of of a central bank
loss function that attaches a non-zero penalty to output gap ‡uctuations, in addition
to in‡ation ‡uctuations, whenever there is a tradeo¤ between the stabilization of both
variables.

1
2 The Monetary Policy Problem: the Case
of an E¢ cient Steady State
When nominal rigidities coexist with real imperfections, the ‡exible price
equilibrium allocation is generally ine¢ cient. In that case, it is no longer
optimal for the central bank to seek to replicate that allocation. On the
other hand, any deviation of economic activity from its natural (i.e. ‡exible
price) level generates variations in in‡ation, with the consequent relative
price distortions.
A special case of interest arises when the possible ine¢ ciencies associated
with the ‡exible price equilibrium do not a¤ect the steady state, which re-
mains e¢ cient. The present section analyzes the optimal monetary policy
problem under that assumption. In contrast with the analysis in chapter
4, however, here we allow for short run deviations between the natural and
e¢ cients levels of output. More precisely, we assume that the gap between
the two follows a stationary process, with a zero mean. Implicitly, we are as-
suming the presence of some real imperfections that generate a time-varying
gap between output and its e¢ cient counterpart, even in the absence of price
rigidities.
In that case, and as shown in the appendix, the welfare losses experienced
by the representative household are, up to a second order approximation,
proportional to
X
1
t 2
E0 f t + x x2t g (1)
t=0

where xt yt yte denotes the welfare-relevant output gap, i.e. the deviation
between (log) output yt and its e¢ cient level yte . As before t pt pt 1
denotes the rate of in‡ation between periods t 1 and t. Coe¢ cient x
represents the weight of output gap ‡uctuations (relative to in‡ation) in the
loss function, and is given by x = where is the coe¢ cient on xt in the
new Keynesian Phillips curve (NKPC), and is the elasticity of substitution
between goods. More generally, and stepping beyond the welfare-theoretic
justi…cation for (1), one can interpret x as the weight attached by the central
bank to deviations of output from its e¢ cient level (relative to price stability)
in its own loss function, which does not necessarily have to coincide with the
household’s.
A structural equation relating in‡ation and the welfare-relevant output

2
gap can be derived by using the identity yet xt + (yte ytn ), to substitute
for the output gap yet in the NKPC relationship derived in chapter 3. This
yields the following structural equation for in‡ation

t = Et f t+1 g + x t + ut (2)
where ut (yte ytn ).
Hence, the central bank will seek to minimize (1) subject to the sequence
of constraints given by (2). Two features of that problem are worth stressing.
First, note that, under our assumptions, the disturbance ut is exogenous with
respect to monetary policy, since the latter can in‡uence neither the natural
nor the e¢ cient level of output. As a result, the central bank will take the
current and anticipated values of ut as given when solving its policy problem.
Secondly, and most importantly, time variations in the gap between the
e¢ cient and natural levels of output–re‡ected in ‡uctuations in ut –generate
a tradeo¤ for the monetary authority, since they make it impossible to attain
simultaneously zero in‡ation and an e¢ cient level of activity. This is a key
di¤erence from the model analyzed in the previous chapter, where we had
ytn = yte for all t, thus implying ut = 0 for all t. In the appendix we discuss
several potential sources of variation in the gap between the e¢ cient and
natural levels of output, including exogenous changes in desired price or
wage markups, as well as ‡uctuations in labor income taxes. Nevertheless,
at least for the purposes of the analysis in the present chapter, knowledge of
the speci…c source of that gap is not important.
Following much of the literature, we refer to disturbance ut in (2) as a
cost-push shock. Also, and for the remainder of this chapter, we assume that
ut follows the exogenous AR(1) process:

ut = u ut 1 + "ut (3)
where u 2 [0; 1), and f"ut g is a white noise process with constant variance
2
u.

While (2) is the only constraint needed in order to determine the equilib-
rium path for output and in‡ation under the optimal policy, implementation
of that policy requires that we make use of an additional condition linking
those variables with the monetary policy instrument, i.e. the interest rate.
That condition can be obtained by rewriting the dynamic IS equation …rst
derived in chapter 3 in terms of the welfare-relevant output gap,

3
 1
xt = (it Et f t+1 g rte ) + Et fxt+1 g (4)

where rte + Et f yt+1e

g is the interest rate that supports the e¢ cient
allocation, and which is invariant to monetary policy. Henceforth, we refer
to rte as the e¢ cient interest rate.
The forward-looking nature of constraint (2) in the policy problem, re-
quires that we specify the extent to which the central bank can credibly
commit in advance to future policy actions. As will be clear below, the rea-
son is that by committing to some future policies the central bank is able to
in‡uence expectations in a way that improves its short-run tradeo¤s. The
following two sections characterize the optimal monetary policy under two
alternative (and extreme) assumptions regarding the central bank’s ability
to commit to future policies.

2.1 Optimal Discretionary Policy

We start by considering the case in which the central bank treats the prob-
lem described above as one of sequential optimization, i.e. it makes whatever
decision is optimal each period without committing itself to any future ac-
tions. That case if often referred to in the literature as optimal policy under
discretion.
More especi…cally, each period the monetary authority is assumed to
choose (xt ; t ) in order to minimize the period losses
2
t + x x2t

subject to the constraint

t = xt + vt
where the term vt Et f t+1 g + ut is taken as given.by the monetary au-
thority, since ut is exogenous and Et f t+1 g is a function of expectations about
future output gaps (as well as future ut ’s) which, by assumption, cannot be
currently in‡uenced by the policymaker.2
2
To be precise, the term Et f t+1 g can be treated as given by the central bank because
there are no endogenous state variables (e.g. past in‡ation) a¤ecting current in‡ation.
Otherwise the central bank would have to take into account the in‡uence that its current
actions, through their impact on those state variables, would have on future in‡ation.

4
 The optimality condition for the problem above is given by

xt = t (5)
x

for t = 0; 1; 2; :::The previous condition has a simple interpretation: in the

face of in‡ationary pressures resulting from a cost-push shock the central
bank must respond by driving output below its e¢ cient level–thus creating a
negative output gap–, with the objective of dampening the rise in in‡ation.
The central bank carries out such a "leaning against the wind" policy up
to the point where condition (5) is satis…ed. Thus, one can view (5) as
a relation between target variables that the discretionary central bank will
seek to maintain at all times and it is in that sense that may be labeled a
"targeting rule."3
Using (5) to substitute for xt in (2), yields the following di¤erence equa-
tion for in‡ation:
x x
t = 2
Et f t+1 g + 2
ut
x+ x+

Iterating the previous equation forward we obtain an expression for equi-

librium in‡ation under the optimal discretionary policy:

t = x ut (6)
1
where 2+
x (1
. Combining (5) and (6) we get an analogous expres-
u)
sion for the output gap.
xt = ut (7)
Thus, under the optimal discretionary policy, the central bank lets the
output gap and in‡ation deviate from their targets in proportion to the
current value of the cost-push shock. This is illustrated graphically by the
circled lines in Figures 5.1 and 5.2, which represent the responses under the
optimal discretionary policy of the output gap, in‡ation and the price level
to a one-percent increase in ut . In Figure 5.1 the cost-push shock is assumed
to be purely transitory ( u = 0), whereas in Figure 5.2 we assume it has a
positive autocorrelation ( u = 0:5). The remaning parameters are set at the
values assumed in the baseline calibration of chapter 3.
3
See, e.g. Svensson (1998) and Svensson and Woodford (1999) for a discussion of
"targeting" vs "instrument" rules as alternative approaches to implementation of in‡ation
targeting policies.

5
 The path of the cost-push shock ut after a one percent innovation is
displayed in the bottom-right plot of Figures 5.1 and 5.2 . In both cases we see
that the central bank …nds it optimal to accommodate partly the in‡ationary
pressures resulting from the cost-push shock, and thus let in‡ation increase.
Note, however, that the increase in in‡ation is smaller than the one that
would obtain if the output gap remained unchanged. In the latter case it is
easy to check that in‡ation would be given by
1
t = ut
1 u

thus implying a larger response of in‡ation (in absolute value) at all horizons
in response to the cost-push shock. Instead, under the optimal discretionary
policy, the impact on in‡ation is dampened by the negative response of the
output gap, also displayed in both …gures. Finally, we see that the implied
response of in‡ation leads naturally to a permanent change in the price level,
whose size is increasing in the persistence of the shock.

The analysis above implicitly assumes that the monetary authority can
choose its desired level of in‡ation and the output gap at each point in
time. Of course, in practice a central bank cannot set either variable directly.
One possible approach to implementing that policy is to adopt an interest
rate rule that guarantees that the desired outcome is attained. Before we
derive the form that such a rule may take it is convenient to determine the
equilibrium interest rate under the optimal discretionary policy as a function
of the exogenous driving forces. Thus, combining (6) and (7) with (4) we
obtain:

it = rte + i ut (8)
where i [ (1 u) + x u]
Applying the arguments of chapter 3, it is easy to see that (8) cannot be
viewed as a desirable interest rate rule, for it does not guarantee a unique
equilibrium and, hence, the attainment of the desired outcome. In particu-
lar, if we use "rule" (8) to eliminate the nominal rate in (4), the resulting
equilibrium dynamics are represented by the system:

xt Et fxt+1 g
= AO + BO ut (9)
t Et f t+1 g

6
where
1
1 i
AO ; BO
+ 1 i

As argued in chapter 4, matrix AO has always one eigenvalue outside the

unit circle, thus implying that (9) has a multiplicity of solutions, only one of
which corresponds to the desired outcome given by (6) and (7).
Consider instead the rule

it = rte + t (10)
where (1 u ) x + u , and which can be obtained by combining (6)
and (8), in a way that makes the nominal rate a function of in‡ation, an
endogenous variable. It is easy to check that the previous rule is always con-
sistent with the desired outcome of the policy problem under consideration
here. Furthermore, using the arguments of chapter 4, we know that a rule
of the form (10) leads to a determinate equilibrium (corresponding to the
desired outcome) if and only if the in‡ation coe¢ cient is greater than one
or, equivalently, if and only if > x a condition that may or may not be
satis…ed.
In the context of our model, one can always derive a rule that guarantees
equilibrium uniqueness (independently of parameter values) by appending
to the expression for the equilibrium nominal rate under the optimal discre-
tionary policy (given by (8)) a term proportional to the deviation between
in‡ation and the equilibrium value of the latter under that policy, with the
coe¢ cient of proportionality being greater than one (in order to satisfy the
Taylor principle). Formally,

it = rte + i ut + ( t x ut ) (11)
= rte + i ut + t

where i [ (1 u) x( u )] and for an arbitrary in‡ation

coe¢ cient satisfying > 1.
In practice, interest rate rules like (10) and (11) are not easy to implement,
for the reasons spelled out in chapter 4: they require knowledge of the model’s
parameters, and real-time observation of variations in the cost-push shock
and the e¢ cient interest rate. Those di¢ culties have led some authors to
emphasize "targeting rules" like (5) as practical guides for monetary policy,
as opposed to "instrument rules" like (10) and (11). Under a targeting rule,

7
the central bank would adjusts its instrument until a certain optimal relation
between target variables is satis…ed. In our example, however, following such
a targeting rule requires that the e¢ cient level of output yte be observed in
real time, in order to determine the output gap xt .

2.2 Optimal Policy under Commitment

After having analyzed the optimal policy under discretion, we turn to the
case of a central bank which is assumed to be able to commit, with full
credibility, to a policy plan. In the constext of our model such a plan consists
of a speci…cation of the desired levels of in‡ation and the output gap at all
possible dates and states of nature, current and future. More speci…cally,
the monetary authority is assumed to choose a state-contingent sequence
fxt ; t g1
t=0 that minimizes

1 X 1
t 2
E0 ( t + x x2t )
2 t=0
subject to the sequence of constraints:

t = Et f t+1 g + x t + ut
and where, as in the previous section, fut g follows the exogenous process (3).
In order to solve the previous problem it is useful to write down the
associated Lagrangian, which is given by:
X
1
1
t 2
L = E0 t + x x2t + t ( t xt t+1 )
t=0
2
where f t g is a sequence of Lagrange multipliers, and where the law of it-
erated expectations has been used to eliminate the conditional expectation
that appeared in each constraint.
Di¤erentiating the Lagrangian with respect xt and t we obtain the op-
timality conditions
x xt t = 0

t + t t 1 =0
which must hold for t = 0; 1; 2; :::and where 1 = 0, since the in‡ation
equation corresponding to period -1 is not an e¤ective constraint for the
central bank choosing its optimal plan in period 0.

8
 Combining the two optimality conditions to eliminate the Lagrange mul-
tipliers yields
x0 = 0 (12)
x
and
xt = xt 1 t (13)
x
for t = 1; 2; 3; :::..
Note that (12) and (13) can be jointly represented by the single equation
in "levels":
xt = pbt (14)
x
for t = 0; 1; 2; :::where pbt pt p 1 is the (log) deviation between the price
level and an "implicit target" given by the price level prevailing one period
before the central bank chooses its optimal plan. Thus, (14) can be viewed
as a "targeting rule" which the central bank must follow period by period in
order to implement the optimal policy under commitment.
It is worth pointing out the di¤erence between (14) and the corresponding
targeting rule for the discretionary case, given by (5). Thus, the optimal dis-
cretionary policy requires that the central bank keeps output below (above)
its e¢ cient level as long as in‡ation is positive (negative). By way of contrast,
under the optimal policy with commitment the central bank sets the sign and
size of the output gap in proportion to the deviations of the price level from
its implicit target. As we discuss next, this has important consequences for
the economy’s equilibrium response to a cost push shock.
By combining optimality condition (14) with (2) (after rewriting the latter
in terms of the price level) we can derive the stochastic di¤erence equation
satis…ed by pbt under the optimal policy:
pbt = a pbt 1 + a Et fb
pt+1 g + a ut
for t = 0; 1; 2; :::where a x
x (1+ )+
2.

The stationary solution to the previous di¤erence equation is given by:

pbt = pbt 1 + ut (15)

(1 u)
p
1 1 4 a2
for t = 0; 1; 2; :::where 2a
2 (0; 1): We can then use (14) to derive
the equilibrium process for the output gap:

xt = xt 1 ut (16)
x (1 u)

9
for t = 1; 2; 3; :::, with the response at the time of the shock (t = 0) being
given by
x0 = u0
x (1 u)
The lines with crosses in Figure 5.1 show the equilibrium responses of the
output gap, in‡ation, and the price level to a one percent transitory cost-push
shock. Analogous responses for the case of a persistence cost-push shock are
displayed in Figure 5.2 . In both cases those responses are shown side by side
with the responses implied by the optimal discretionary policy (represented
by the circled lines described earlier), thus facilitating comparison of the two
regimes’outcomes.
A look at the case of a transitory cost-push shock illustrates the di¤erence
most clearly. In the case of discretionary policy, both the output gap and
in‡ation return to their zero initial value once the shock has vanished (i.e.
one period after the shock). By contrast, and as implied by (15) and (16),
under the optimal policy with commitment the deviations in the output gap
and in‡ation from target persist well beyond the life of the shock, i.e. they
display endogenous or intrinsic persistence. Given that a zero in‡ation, zero
output gap outcome is feasible once the shock has vanished, why does the
central bank …nd it optimal to maintain a persistently negative output gap
and in‡ation? The reason is simple: by committing to such a response,
the central bank manages to improve the output gap/in‡ation tradeo¤ in
the period when the shock occurs. In the case illustrated in Figure 5.1 it
lowers the initial impact of the cost-push shock on in‡ation (relative to the
discretionary case), while incurring smaller output gap losses in the same
period. This is possible because of the forward-looking nature of in‡ation,
which can be highlighted by iterating (2) forward to yield:
X
1
k
t = xt + Et fxt+k g + ut
k=1

Hence, we see that the central can o¤set the in‡ationary impact of a cost
push shock by lowering the current output gap xt , but also by committing
to lower future output gaps (or, equivalently, future reductions in the price
level). If credible, such "promises" will bring about a downward adjustment
in the sequence of expectations Et fxt+k g for k = 1; 2; 3,....As a result, and in
response to a positive realization of the cost-push shock ut , the central bank
may achieve any given level of current in‡ation t with a smaller decline in

10
the current output gap xt . That is the sense in which the output gap/in‡ation
tradeo¤ is improved by the possibility of commitment. Given the convexity
of the loss function in in‡ation and output gap deviations, the dampening
of those deviations in the period of the shock brings about an improvement
in overall welfare relative to the case of discretion, since the implied bene…ts
are not o¤set by the (relatively small) losses generated by the deviations in
subsequent periods (and which are absent in the discretionary case).
Figure 5.2 displays analogous impulse responses under the assumption
that u = 0:8. Note that in this case the economy reverts back to the initial
position only asymptotically, even under the optimal discretionary policy
(since the in‡ationary pressures generated by the shock remains e¤ective
at all horizons, albeit with a declining in‡uence). Yet, some of the key
qualitative features emphasized above are still present: in particular, the
optimal policy with commitment manages once again to attain both lower
in‡ation and a smaller output gap (in absolute value) at the time of the
shock, relative to the optimal discretionary policy. Note also that under the
optimal policy with commitment the price level reverts back to its original
level, albeit at a slower rate than in the case of a transitory shock. As a
result in‡ation displays some positive short run autocorrelation, illustrating
the fact that the strong negative short run autocorrelation observed in the
case of a purely transitory shock is not a necessary implication of the policy
with commitment.
In all cases, a feature of the economy’s response under discretionary policy
is the attempt to stabilize the output gap in the medium term more than the
optimal policy under commitment calls for, without internalizing the bene…ts
in terms of short-term stability that result from allowing larger deviations of
the output gap at future horizons. This characterisctic, which is most clearly
illustrated by the example of a purely transitory cost-push shock represented
in Figure 5.1, is often referred to as the stabilization bias associated with the
discretionary policy.4
As in the case of discretion, one might be interested in deriving an interest
rate rule that would bring about the paths of output gap and in‡ation implied
by the optimal policy under commitment. Next we derive such a rule for the
4
That stabilization bias must be distinguished from the in‡ation bias which arises when
the zero in‡ation steady state is associated with an ine¢ ciently low level of activity. The
stabilization bias obtains independently of the degree of ine¢ ciency of the steady state,
as discussed below.

11
special case of serially uncorrelated cost push shocks ( u = 0). In that
case, we can combine (4), (15) and (16) to obtain the process describing the
equilibrium nominal rate under the optimal policy with commitment:

it = rte (1 ) 1 pbt
x
X
t
k+1
= rte (1 ) 1 ut k
x
k=0

Thus, one possible rule that would brIng about the desired allocation as
the unique equilibrium is given by
X
t
k+1
it = rte + (1 ) 1 ut k + p pbt
x
k=0

for any p > 0. Note that under the previous formulation the central bank
stands ready responds to any deviation of the price level from the path pre-
scribed by (15), though this will not be necessary in equilibrium.5

3 The Monetary Policy Problem: the Case

of a Distorted Steady State
Next we consider the case in which the presence of uncorrected real imperfec-
tions generate a permanent gap between the natural and the e¢ cient levels
of output, which is re‡ected in an ine¢ cient steady state. We measure the
size of the steady state distortion by a parameter representing the wedge
between the marginal product of labor and the marginal rate of substitu-
tion between consumption and hours, both evaluated at the steady state.
Formally, is de…ned by
Un
= M P N (1 )
Uc
Below we assume > 0, which implies that the steady state levels of
output and employment are below their respective e¢ cient levels. The pres-
ence of …rms’ market power in the goods market as assumed in the basic
5
An interest rate rule that displays a positive response to the price level can be shown
to genrate a unique equilibrium in the basic new Keynesian model. See exercise 5 in
chapter 4.

12
model of chapter 3 constitutes an example of the kind of distortion which, if
uncorrected through an appropriate subsidy, would generate an ine¢ ciently
low level of activity. In that case, and as implied by the analysis of chapter
1
4, we have 1 M > 0, where M is the steady state gross markup.
Under the assumption of a "small" steady state distortion (i.e. when
has the same order of magnitude as ‡uctuations in the output gap or in‡a-
tion), and as shown in the Appendix to the present chapter, the component
of the welfare losses experienced by the representative household that can be
a¤ected by policy is approximately proportional, in a neighborhood of the
zero in‡ation steady state, to the expression
X
1
1
t 2
E0 ( t + x b2t )
x bt
x (17)
t=0
2

where > 0 and xbt = xt x represents the deviation of the welfare-

relevant output gap from its value x < 0 in the zero in‡ation steady state.
Note that the linear term x bt captures the fact that any marginal increase in
output has a positive e¤ect on welfare (thus increasing welfare losses), since
output is assumed to be below its e¢ cient level.
bt as
Similarly, we can write the in‡ation equation in terms of x

t = Et f t+1 g + bt + ut
x (18)

where now ut yte ybtn ). Thus the monetary authority will seek to mini-
(b
mize (17) subject to the sequence of constraints given by (18) for t = 0; 1; 2; :::
Note that under the assumption of a "small" steady state distortion made
above, the linear term x bt is already of second order, thus giving the central
bank’s problem the convenient linear-quadratic format.6
As in the previous section, we characterize the solution to the central
bank’s problem under discretion, before turning to the optimal policy with
commitment.
6
In the presence of a large distortion, the presence of a linear term in (17) would require
the use of a second order approximation to the equilibrium condition connecting outpup
gap and in‡ation.

13
3.1 Optimal Discretionary Policy
In the absence of a commitment technology, the monetary authority chooses
(xt ; t ) in order to minimize the period losses
1 2
( t + x b2t )
x bt
x
2
subject to the constraint
t = bt + vt
x
where, once again, vt Et f t+1 g + ut is taken as given by the policymaker.
The associated optimality condition is

bt =
x t (19)
x x

Note that (19) implies, for any given level of in‡ation, a more expan-
sionary policy than in the absence of a steady state distortion. This is a
consequence of the desire by the central bank to partly correct for the inef-
…ciently low average level of activity.
Plugging (19) into (18) and solving the resulting di¤erence equation yields
the following expression for equilibrium in‡ation:

t = 2
+ x ut (20)
+ x (1 )
Combining (20) and (19) yields the corresponding expression for the equi-
librium output gap:
(1 )
bt =
x 2
ut
+ x (1 )
Thus, we see that the presence of a distorted steady state does not a¤ect
the response of the output gap and in‡ation to shocks under the optimal
policy. It has, however, an e¤ect on the average levels of in‡ation and the
output gap around which the economy ‡uctuates. In particular, when the
natural level of output and employment are ine¢ ciently low ( > 0) the opti-
mal discretionary policy leads to positive average in‡ation, as a consequence
of the central bank’s incentive to push output above its natural steady state
level.7 That incentive increases with the degree of ine¢ ciency of the natural
steady state, which explains the fact that the average in‡ation is increasing
in (and hence in ), giving rise to the classical in‡ation bias phenomenon.
7
b=y
Notice that in the steady state x yn

14
3.2 Optimal Policy under Commitment
As in the case of an e¢ cient steady state, we solve for the optimal policy
under commitment by setting up the Lagrangean corresponding to the central
bank’s problem, which in this case is given by
X
1
1
t 2
L = E0 ( t + x b2t )
x bt +
x t ( t bt
x t+1 )
t=0
2

where f t g are the Lagrange multipliers associated with the sequence of

constraints (18), for t = 0; 1; 2; :::
The corresponding optimality conditions are given by

x bt
x t =0

t + t t 1 =0
which must hold for t = 0; 1; 2; :::and where 1 = 0. The previous conditions
can be combined to yield the following di¤erence equation for the (log) price
level:
pbt = a pbt 1 + a Et fbpt+1 g + + a ut
for t = 0; 1; 2; :::where, as above, pbt pt p 1 , and a x
x (1+ )+
2.

The stationary solution to the previous di¤erence equation describes the

evolution of the equilibrium price level under the optimal policy with com-
mitment. It takes the following form:

pbt = pbt 1 + ut +
1 u 1
p
1 1 4 a2
where 2a
2 (0; 1). The corresponding path for the output gap is
given by:
2
bt =
x bt
x 1 ut + 1 1+
x (1 u) x (1 )
Thus, as it was the case under the discretionary policy, the response to
a cost-push shock under the optimal policy with commitment is not a¤ected
by the presence of a distorted steady state. Hence the impulse responses
displayed in Figures 5.1 and 5.2 illustrating the economy’s response to a

15
cost-push shock under discretion and under commitment, remain valid in
the present context. In particular, the optimal policy under discretion is
characterized by an identical stabilization bias.
In the presence of a distorted steady state, an additional di¤erence arises
between the discretionary and commitment policies, unrelated to the re-
sponse to shocks: it has to do with the deterministic component of in‡a-
tion and its evolution over time. As shown above, in the case of discretion
that component takes the form a constant positive mean, resulting from the
period-by-period incentive to close the gap between output and its e¢ cient
level, which results in in‡ation. In the case of commitment, however, we
see that the price level converges asymptotically to a constant, given by
limT !1 pT = p 1 + (1 )(1 ) . Hence, after displaying a positive value at
the beginning of the optimal plan’s implementation, the deterministic com-
ponent of in‡ation (around which actual in‡ation ‡uctuates in response to
t+1
shocks) declines gradually over time, following the path 1 . Hence, under
the optimal plan the economy eventually converges to an equilibrium charac-
terized by zero average in‡ation, and in that sense observationally equivalent
to that of an economy with an e¢ cient steady steady state. The desirability
of such a policy is justi…ed by the bene…ts arising from its anticipation by
the public, which improves the short-run tradeo¤ facing the central bank,
allowing it to raise output above its natural level (with the consequent wel-
fare improvement) with more subdued e¤ects on in‡ation (since the public
anticipates a gradual return of output to its natural level) . Thus, the central
bank’s ability to commit avoids (at least asymptotically) the in‡ation bias
that characterizes the outcome of the discretionary policy.

4 Notes on the Literature

The present chapter follows closely Clarida, Galí and Gertler (1999), where
the optimal monetary policy in the context of the basic new Keynesian model
augmented with an ad-hoc cost-push shocks is analyzed, and where the out-
comes under discretion and commitment are compared. That paper also
contains a discussion of the classical in‡ation bias, whose ultimate source
is modeled as a positive target for the output gap in the policymaker’s loss
function. The original treatment of the in‡ation bias and the gains from
commitment, in the context of a new classical model with a Lucas supply
curve, can be found in Kydland and Prescott (1980) and Barro and Gordon

16
(1983).
Woodford (2003a) discusses a source of monetary policy tradeo¤s di¤erent
from cost-push shocks: that created by the presence of transactions friction
which leads to an indirect utility function in which real balances are one of
the arguments, as in the model at the end of chapter 2. In that context,
and in addition to variations in in‡ation and the output gap, variations in
the nominal rate (which acts as a tax on money holdings) are a source of
welfare losses. As a result, a policy that fully stabilizes the output gap
and in‡ation by making the interest rate move one-for-one with the natural
rate, while feasible, it is no longer optimal since it implies excessive interest
rate volatility. The optimal policy, as shown by Woodford, smoothens the
‡uctuations in the nominal rate, at the cost of some variations in in‡ation
and output gap.
The approximation to welfare in the presence of "small" steady state
distortions presented here follows the analysis in Woodford (2003b). The
analysis of optimal policy in the presence of "large" steady state distortions
lies beyond the scope of the present book. The main di¢ culty in that case
arises from the presence of a linear term in the second-order approximation
to the welfare loss function. In that context, the use of a log-linear (i.e. …rst
order) approximation to the equilibrium conditions to describe the evolution
of endogenous variables leads to second-order terms potentially relevant to
welfare being ignored (e.g. the ones associated with the steady state e¤ects
of di¤erent degrees of volatility).
Several approaches to overcoming that problem are found in the litera-
ture. A …rst approach consists in solving for the evolution of the endogenous
variables using a second-order (or higher) approximation to the equilibrium
conditions under a given policy rule, and evaluating the latter using the orig-
inal second-order approximation to the welfare losses. An application of that
approach to the monetary policy problem can be found in Schmitt-Grohé
and Uribe (2004), among others.
The second approach, due to Benigno and Woodford (2005), makes use
of a second-order approximation to the structural equations of the model
in order to replace the linear terms appearing in the welfare loss function,
and rewriting those losses as a function of quadratic terms only. The result-
ing quadratic loss function can then be minimized subject to the constraints
provided by log-linearized equilibrium conditions. That approach allows one
to preserve the convenient structure and properties of linear-quadratic prob-
lems, including the linearity of their implied optimal policy rules.

17
 A third approach, illustrated in Khan, King and Wolman (2003), requires
that the optimal policy be determined in a …rst stage using the exact struc-
tural equations and utility function, and log-linearizing the resulting equilib-
rium conditions (embedding the optimal policy) in order to characterize the
optimal responses to shocks.

18
 Appendix 1: A Second Order Approximation to Welfare Losses
in the Case of a Small Steady State Distortion
As shown in the appendix to chapter 4, a second order Taylor expansion
to period t utility, combined with a goods market clearing condition, yields:
1 Un N 1+'
Ut U = Uc C ybt + ybt2 + ybt + vari fpt (i)g + (b
yt at )2 +t:i:p::
2 1 2 2(1 )
where t:i:p: stands for "terms independent of policy".
Let denote the size of the steady state distortion, implicitly de…ned by
Un
Uc
= M P N (1 ). Using the fact that M P N = (1 )(Y =N ) we have

Ut U 1 1+'
= ybt + ybt2 (1 ) ybt + vari fpt (i)g + (b
yt at )2 +t:i:p:
Uc C 2 2 2(1 )
Under the "small distortion" assumption (so that the product of with
a second order term can be ignored as negligible) we can write:
Ut U 1 1+'
= ybt vari fpt (i)g (1 ) ybt2 + (b
yt at )2 + t:i:p:
Uc C 2 1
1 '+ 1+'
= yet vari fpt (i)g + + ybt2 2 ybt at + t:i:p:
2 1 1
1 '+
= yet vari fpt (i)g + + yt2
(b yt ybte ) + t:i:p:
2b
2 1
1 '+
= bt
x vari fpt (i)g + + b2t + t:i:p:
x
2 1
where ybte yte y e , and where we have used the fact that ybte = (1 1+'
)+'+
at
e e
.and ybt ybt = xt (y y ) = xt x x bt .
Accordingly, we can write a second order approximation to the consumer’s
welfare losses (up to additive terms independent of policy), and expressed as
a fraction of steady state consumption, as:

X
1
Ut U X
1
1 '+
t t
W = E0 = E0 bt
x vari fpt (i)g + + b2t
x +t:i:p:
t=0
Uc C t=0
2 1

Using Lemma 2 in the appendix of chapter 4, we can rewrite the welfare

losses as

19
 X
1
1 '+
t 2
W = E0 bt
x t + + b2t + t:i:p:
x
t=0
2 1

Note that in the particular case of an e¢ cient steady state we have = 0

and x bt = xt . Moreover, if as in Chapter 4 the model satis…es ytn = yte for all
t , the we have xbt = xt = yet ., with the implied loss function taking the form
used in that Chapter.

20
 Appendix 2: Sources of Cost Push Shocks

The present appendix describes two possible sources of cost-push shocks,

variations in desired price markups and exogenous variations in wage markups.
Variations in desired price markups.
Assume that the elasticity of substitution among goods varies over time,
according to some stationary stochastic process f t g. Let the associated
desired markup be given by nt t
t 1
.The log-linearized price setting rule
is then given by:
X
1
pt = (1 ) ( )k Et f n
t+k + mct+k + pt+k g
k=1
X
1
= (1 ) ( )k Et fmc
f t+k + pt+k g
k=1

n
ft
where mc mct + t The resulting in‡ation equation then becomes

t = Et f t+1 g + ft
mc
= Et f t+1 g + c t + ( nt
mc )
n n
= Et f t+1 g + (yt y t ) + ( t )

where y nt denotes the equilibrium level of output under ‡exible prices and
a constant price markup . Letting xt yt y nt and ut ( nt ) we
obtained the formulation used in the main text.

Exogenous Variations in Wage Markups

In that case we still have t = Et f t+1 g + c t , though now
mc

mct = wt at
= w;t + mrst at
= w;t + ( + ') yt (1 + ') at

where w;t represents a time-varying, exogenous wage markup. Under ‡exible

prices and a constant wage markup (at its steady state level w ), we have

mc = w + ( + ') y nt (1 + ') at

where y nt denotes the equilibrium level of output under a constant price and
wage markup.

21
 The di¤erence between the two previous expression is thus given by

c t = ( + ') (yt
mc y nt ) + ( w;t w)

which can be plugged into the in‡ation equation to yield

t = Et f t+1 g + xt + u t

where xt yt y nt and ut ( w;t w ).

22
 References
Barro, Robert J., and David Gordon (1983): “A Positive Theory of Mon-
etary Policy in a Natural Rate Model,” Journal of Political Economy 91, 4,
589-610.
Benigno, Pierpaolo, and Michael Woodford (2005): “In‡ation Stabiliza-
tion and Welfare: the Case of a Distorted Steady State” Journal of the
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of Monetary Policy: A New Keynesian Perspective,” Journal of Economic
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timal Monetary Policy,”Review of Economic Studies, 825-860.
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Discretion: The Inconsistency of Optimal Plans,”Journal of Political Econ-
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23
 Exercises
1. An Optimal Taylor Rule
Consider an economy with Calvo-type staggered price setting whose equi-
librium dynamics are described by the system:
1
xt = Et fxt+1 g (it Et f t+1 g ) + "t

t = Et f t+1 g + x t + ut
where f"t g and fut g are i:i:d:, mutually uncorrelated, demand and supply
disturbances, with variances given by 2" and 2u respectively
Assume that the monetary authority adopts a simple Taylor rule of the
form
it = + t

a) Solve for the equilibrium processes for the output gap and in‡ation, as
a function of the exogenous supply and demand shocks.
b) Determine the value of the in‡ation coe¢ cient which minimizes the
central bank’s loss function:

x var(xt ) + var( t )

c) Discuss and provide intuition for the dependence of the optimal in‡a-
var(")
tion coe¢ cient on the weight x and the variance ratio var(u) : What assump-
tions on parameter values would warrant an aggressive response to in‡ation,
implemented thorugh a large ? Explain.

2. Optimal Markovian Policy

Consider an economy where in‡ation is described by the augmented NKPC

t = Et f t+1 g + x t + ut

where fut g is an exogenous cost-push shock following a stationary AR(1)

process
ut = u ut 1 + "ut

24
 In period 0, the central bank chooses once and its policy among the class
of Markovian policies of the form xt = x ut and t = ut for all t, in order
to minimize the loss function
X
1
t 2
E0 t + x x2t
t=0

subject to the sequence of constraints describing the evolution of in‡ation.

a) Determine the optimal values of x and :
b) Compare the resulting optimal policy to the optimal discretionary
policy analyzed in the chapter. Which one is more desirable from a welfare
point of view? Explain
c) Compare the resulting optimal policy to the optimal policy under com-
mitment analyzed in the chapter. Which one is more desirable from a welfare
point of view? Explain.

3. Optimal Monetary Policy in the Presence of Transaction

Frictions (based on Woodford (2003a))
As shown in Woodford (2003a), in the presence of real balances as a
source of indirect utility in an otherwise standard NK model, a second order
approximation to the representative household’s welfare is proportional to:

1 X 1
t 2
E0 t + x x2t + i i2t
2 t=0
1
Consider the problem of choosing the state-contingent policy fxt ; t gt=0
that maximizes welfare subject to the sequence of constraints:

t = Et f t+1 g + xt
1
xt = (it Et f t+1 g rtn ) + Et fxt+1 g
for t = 0; 1; 2; :::where the natural rate rtn is assumed to follow an exogenous
process.
a) Determine the optimality conditions for the problem described above
b) Show that the implied optimal policy can be implemented by means
of an interest rate rule of the form
1 x
it = (1 + ) it 1 + it 1 + t+ xt
i i

25
which is independent of rtn and its properties.

4. In‡ation Persistence and Monetary Policy (based on Steinsson

(2003))

As shown in Steinsson (2003), in the presence of partial price indexation

by …rms the second order approximation to the the household’s welfare losses
takes the form:

1 X 1
t
E0 [ x x2t + ( t
2
t 1) ]
2 t=0

where denotes the degree of price indexation to past in‡ation. The equation
describing the evolution of in‡ation is now given by:

t t 1 = xt + Et f( t+1 t )g + ut
where ut represents an exogenous i:i:d: cost-push shock.
a) Determine the optimal policy under discretion, i.e. under the assump-
tion that the monetary authority seeks to minimize each period the short-
term losses x x2t + ( t t 1)
2

b) Determine the optimal policy under commitment

c) Discuss how the degree of indexation a¤ects the optimal responses
to a transitory cost-push shock under the previous two scenarios.

5. Monetary Policy, Optimal Steady State In‡ation and the

Zero Lower Bound
Consider a new Keynesian model with equilibrium conditions given by
1
xt = Et fxt+1 g (it Et f t+1 g ) + "t
and
t = Et f( t+1 )g + xt + ut
where xt is the (welfare-relevant) output gap, t denotes in‡ation, it is the
nominal rate, and is steady state in‡ation. The disturbances "t and ut rep-
resent demand and cost-push shocks, and are assumed to follow independent

26
and serially uncorrelated normal distributions with zero mean and variances
2 2
" and u respectively.
Assume that the loss function for the monetary authority is given by
X
1
t
+ E0 x x2t + ( t )2
t=0

where the …rst term is assumed to capture the costs of steady state in‡ation.

(a) Derive the optimal policy under discretion (i.e., the time-consistent
policy, resulting from period-by-period maximization) –including the choice
of steady state in‡ation –, subject to the constraint that the interest rate
hits the zero-bound constraint with only with a 5 percent probability.
(b) Derive an interest rate rule that would implement the optimal allo-
cation derived in (a) as the unique equilibrium.

27
Figure 5.1: Optimal Responses to a Transitory Cost-Push Shock
Figure 5.2 : Optimal Responses to a Persistent Cost Push Shock
 Monetary Policy, In‡ation,
and the Business Cycle

Chapter 6
A Model with Sticky Wages and Prices

Jordi Galí
CREI and UPF
August 2007

Correspondence: Centre de Recerca en Economia Internacional (CREI); Ramon Trias

Fargas 25; 08005 Barcelona (Spain). E-mail: jgali@crei.cat