Monetary Economics

Lecture 7
Optimal policy I

Johan Söderberg

Spring 2012

1 / 41
Optimal policy

I In Lecture 2 we talked about monetary policy in the basic

New Keynesian model
I Simple policy problem because small model and no
endogenous predetermined variables—could be solved by hand
I Larger more complex are not easily solved by hand, but we
must use numerical techniques
I In Lecture 4 we talked about how to solve rational
expectations models; today we will extend those methods to
handle optimal policy

2 / 41
The model

Suppose that the model can be written on the form:

" # " # " #
x1t+1 x C
= A 1t + But + 
Et x2t+1 x2t 0 t+1

where x1t is a n × 1 vector of pre-determined variables, x2t is a

m × 1 vector of forward-looking variables, ut is a l × 1 vector of
instruments, and t is a vector of i.i.d shocks

3 / 41
The model

Let Yt be a vector of target variables:

 
x1t
Yt = D x2t 
 
ut

The central banks period t loss function is assumed to be on the

form
 T  
x1t x1t
T
Lt = Yt ΛYt = x2t  W x2t 
   
ut ut

where Λ and W = D 0 ΛD are symmetric positive semidefinite

matrices

4 / 41
The model

The central bank’s problem is to choose ut to minimize

 T  
∞
X x1t x1t
t
E0 β x2t  W x2t 
  
t=0 ut ut

subject to
" # " # " #
x1t+1 x C
= A 1t + But + 
Et x2t+1 x2t 0 t+1

5 / 41
The model

For future reference, it is useful to note that we can partition the

matrices W , A, and B, so that the central bank’s loss function
reads
 T   
x1t W11 W12 W13 x1t
Lt = x2t  W21 W22 W23  x2t 
    
ut W31 W32 W33 ut

and the model equations

" # " #" # " # " #
x1t+1 A A12 x1t B C
= 11 + 1 ut + 
Et x2t+1 A21 A22 x2t B2 0 t+1

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The model

As an example, consider out basic NK model appended with a

cost-push shock:
1 b 
xt = Et xt+1 − it − Et πt+1
σ
πt = κxt + βEt πt+1 + ut
ut = ρut−1 + εt

with the central bank’s loss function given by

Lt = πt2 + αx xt2

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The model

The matrix representation of the model is:

  
1 0 0 ut+1
0 β 0 Et πt+1  =
  
0 1/σ 1 Et xt+1
      
ρu 0 0 ut 0 1
−1 1 −κ πt  +  0  bit + 0 εt+1
      
0 0 1 xt 1/σ 0

Pre-multiplying with the inverse of the left-hand side parameter

matrix we get the model on the desired form

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The model
Defining πt and xt as target variables, we have that
 
" # ut
πt 
0 1 0 0  
Yt =  ,
0 0 1 0  xt 
| {z } bi
t
D
" #
1 0
Λ=
0 αx
and
   
0 0 " #" # 0 0 0 0
1 0 1 0 0 1 0 0 0 1 0 0
W = D T ΛD =  =
   
0 1 0 αx 0 0 1 0 0 0 αx 0
 

0 0 0 0 0 0

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Commitment

Under commitment the central bank chooses a sequence

(state-contingent plan) for the instrument for the entire future
It is convenient to rewrite the model as
   
x1t+1 x1t " #
C
H̄ Et x2t+1  = Ā x2t  + 
   
0 t+1
Et ut+1 ut
h i h i
where H̄ = I 0 and Ā = A B

10 / 41
Commitment

Set up the Lagrangian

      
∞ 
1 x1t+1 x1t " # 
X h i C 
L = E0 βt Lt + ρT ρT H̄ x2t+1  − Ā x2t  − t+1 
     
1t+1 2t 0
t=0 2

ut+1 ut



where ρ1t+1 is an n × 1 vector with Lagrange multipliers for the

upper block of model equations, and ρ2t is an m × 1 vector with
Lagrange multipliers for the lower block of model equations

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Commitment
 
x1t
Let xt = x2t  and write the Lagrangian as
 
ut
∞
( " # !)
X
t 1 T h i C
L = E0 β xt Wxt + ρT ρT H̄xt+1 − Āxt − 
t=0
2 1t+1 2t 0 t+1

To differentiate the Lagrangian, we apply the rules

∂ztT Axt
= ztT A
∂xt
∂xtT Wxt  
= xtT W + (Wxt )T = xtT W + W T = 2xt W
∂xt
where it is assumed that zt is independent of xt and W is
symmetric

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Commitment

The first-order conditions with respect to x1t , x2t and ut are

h i h i h i
T T −1
x1t x2t utT W + ρT
1t ρT T T
2t−1 β H̄ − Et ρ1t+1 ρ2t Ā = 0

given ρ2,−1 = 0
Note that ρ1t is a forward-looking variable and ρ2t is a
pre-determined variable
Taking the transpose and rearranging, the first-order conditions
can be rewritten as
 
" # x1t " #
Et ρ1t+1 ρ1t
ĀT = W x2t  + β −1 H̄ T
 
ρ2t ρ2t−1
ut

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Commitment

Stacking the first order conditions with the model equations we get
the system
     
x1t+1 x1t C
" # E x  " #  x  0
t 2t+1   2t   
H̄ 0  Ā 0
E u =  u  + 0 
     
0 ĀT  t t+1  W β H̄  t    t+1
−1 T
Et ρ1t+1   ρ1t   0 
ρ2t ρ2t−1 0

where the model equations correspond to the upper block of

equations and the first-order conditions to the lower block of
equations.

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Commitment

Using the partitioning of A, B, and W we can write the system as

  
I 0 0 0 0 x1t+1
0 I 0 0 0  Et x2t+1 
 
 
0 0 0 A11 AT
T E u =
  
21   t t+1 
 

0 0 T T
0 A12 A22 Et ρ1t+1
 


0 0 0 B1T B2T ρ2t
    
A11 A12 B1 0 0 x1t C
A
 21 A22 B2 0 0   x2t   0 
   

W11 W12 W13 I/β 0   ut  +  0  t+1
    
    
W21 W22 W23 0 I/β   ρ1t   0 
W31 W32 W33 0 0 ρ2t−1 0

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Commitment
In order to use the QZ-method for solving the system of difference
equation, we need to rearrange the equations so that the
predetermined variables come first.
It is therefore convenient to define new vectors of pre-determined
and forward-looking variables that includes the Lagrange
multipliers and the instruments:
" #
x1t
xe1t =
ρ2t−1

and
 
x2t
xe2t =  ut 
 
ρ1t

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Commitment

Rearranging, we get the system on the desired form

  
I 0 0 0 0 x1t+1
0 AT 0 T
0 A12   ρ2t 
 
 22 
0 0 I 0 0  Et x2t+1  =
  
0 AT 0 AT
   
21 0 11   Et ut+1 
0 B2T 0 0 B1T Et ρ1t+1
    
A11 0 A12 B1 0 x1t C
W
 21 I/β W22 W23 0  ρ2t−1   0 
   

 A21 0 A22 B2 0   x2t  +  0  t+1
    
    
W11 0 W12 W13 I/β   ut   0 
W31 0 W32 W33 0 ρ1t 0

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Commitment

The system can more compactly be written as

" # " # " #
xe1t+1 e xe1t + C t+1
e
H
e =A
Et xe2t+1 xe2t 0
" #
e = C
where C
0
Taking expectations, we get
" # " #
Et xe1t+1 xe
H
e = A 1t
e
Et xe2t+1 xe2t

This system without shocks is straightforward to solve using the

QZ-method

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Commitment
The QZ-decomposition yields the transformed system
" #" # " #" #
S11 S12 Et ye1t+1 T T12 ye1t
= 11
0 S22 Et ye2t+1 0 T22 ye2t

where
" # " #
ye1t xe
= Z −1 1t
ye2t xe2t

The lower block of equations imply that

S22 Et ye2t+1 = T22 ye2t

which yields the solution

−1
ye2t = T22 S22 Et ye2t+1 = 0

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Commitment
Using the fact that ye2t = 0, the upper block of equations imply

S11 Et ye1t+1 = T11 ye1t

or rearranging
−1
Et ye1t+1 = S11 T11 ye1t

To transform back to the original system, note that

xe1t = Z11 ye1t

xe2t = Z21 ye1t

which implies that

xe2t = F xe1t
−1
where F = Z21 Z11
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Commitment

Using the results on the previous slide, the evolution of the

predetermined variables are given by
−1 −1 −1
Et xe1t+1 = Z11 Et ye1t+1 = Z11 S11 T11 ye1t = Z11 S11 T11 Z11 xe1t

Finally, note that

xe1t+1 = Et xe1t+1 + C
e t+1

and we can write the law of motion for xe1t as

xe1t+1 = M xe1t + C
e t+1

−1 −1
where M = Z11 S11 T11 Z11

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Commitment
Note that the optimal rule for ut is given by
" #
x1t
ut = F c
ρ2t−1

The multiplier ρ2t can be written as

ρ2t =M21 x1t + M22 ρ2t−1

=M21 x1t + M22 (M21 x1t−1 + M22 ρ2t−2 )
=...
∞
j
X
= M22 M21 x1t−j
j=0

Optimal policy hence depends on the entire history of x1t

Ensures that the central bank honors past commitments

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Commitment

Properties of optimal policy

I History dependent
I Certainty equivalence
I As we set ρ2,−1 = 0, the policy is time inconsistent
I Policy will be different in the initial period because the central
bank is not bound by past commitments in that period
I Commitment in timeless perspective: choose initial values of
multipliers as if policy always had been in place

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Discretion

Under discretion the central bank in unable to commit to future

policy actions, and there are therefore no past commitments that it
must honor
Instead the policy maker takes expectations as given, leading to a
Nash equilibrium solution
We are looking for a time invariant solution where the law of
motion for the optimal rule and the forward-looking variables are
on the form

ut = Fx1t
x2t = Gx1t

Out task is to find unknown parameters F and G

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Discretion
The central bank’s problem is to choose ut to minimize
 T  
∞
X x1t x1t
E0 β t x2t  W x2t 
   
t=0 ut ut

subject to
" # " # " #
x1t+1 x C
= A 1t + But + 
Et x2t+1 x2t 0 t+1

where

Et x2t+1 = Gt+1 Et x1t+1

This problem can be transformed into a standard linear quadratic

problem without forward-looking variables
25 / 41
Discretion

We begin by eliminating x2t from the model equations

Et x2t+1 = Gt+1 Et x1t+1

A21 x1t + A22 x2t + B2 ut = Gt+1 (A11 x1t + A12 x2t + B1 ut )

Solving for x2t yields

x2t = Āt x1t + B̄t ut

where

Āt = (A22 − Gt+1 A12 )−1 (Gt+1 A11 − A21 )

B̄t = (A22 − Gt+1 A12 )−1 (Gt+1 B1 − B2 )

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Discretion

Substituting x2t into the upper block of model equations yields

x1t+1 = A11 x1t + A12 x2t + B1 ut + C t+1

= A11 x1t + A12 Āt x1t + A12 B̄t ut + B1 ut + C t+1
=A
e t x1t + B
e t ut + C t+1

where

A
e t = A11 + A12 Āt

B
e t = B1 + A12 B̄t

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Discretion

Next, we eliminate x2t from the objective function

 T
   
x1t W11 W12 W13 x1t " #T " #" #
x1t Qt Nt x1t
x2t  W21 W22 W23  x2t  =
    
ut NtT Rt ut
ut W31 W32 W33 ut

where

Qt = W11 + W12 Āt + ĀT T

t W22 Āt + Āt W21
Nt = W13 + W12 B̄t + ĀT T
t W22 B̄t + Āt W23
Rt = W33 + W32 B̄t + B̄tT W22 B̄t + B̄ T W23

28 / 41
Discretion

Because the objective function is quadratic and the constraints are

linear, the value function will be a quadratic function of the
predetermined variables. We can then write the policy problem as
n
T T T
x1t Vt x1t + vt = min x1t Qt x1t + x1t Nt ut + utT NtT x1t + utT Rt ut
ut
 o
T
+βEt x1t+1 Vt+1 x1t+1 + vt+1

subject to

x1t+1 = A
e t x1t + B
e t ut + C t+1

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Discretion

Differenciating with respect to ut , we get the first order condition:

T
x1t Nt + utT Rt + βEt x1t+1
T
Vt+1 B
ft = 0

or substituting for x1t+1 :

 T
T
x1t Nt + utT Rt + β Ax
e 1t + B
e t ut Vt+1 B
ft = 0

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Discretion

Solving for ut , we get the optimal policy rule:

ut = Ft x1t

where
 −1  
Ft = − RtT + β B
e T Vt+1 B
t
et NtT + β B
e T Vt+1 A
t
et

Using the policy rule, we can then write x2t as a function of x1t

x2t =Āt x1t + B̄t ut

 
= Āt + B̄t Ft x1t
=Gt x1t

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Discretion
Substituting the optimal rule for ut in the value function, we get
T T T T T T T T
x1t Vt x1t + vt = x1t Qt x1t + x1t Nt Ft x1t + x1t Ft Nt x1t + x1t Ft Rt Ft x1t
 T  
+βEt A
e t x1t + B
e t Ft x1t + C t+1 Vt+1 A
e t x1t + B
e t Ft x1t + C t+1

+βEt vt+1
or
T T T T T T T T
x1t Vt x1t +vt = x1t Qt x1t + x1t Nt Ft x1t + x1t Ft Nt x1t + x1t Ft Rt Ft x1t
 T  
T e
+βx1t At + B
e t Ft Vt+1 A
et + B
e t Ft x1t
h i
+βEt T T
t+1 C Vt+1 C t+1 + vt+1

Identifying terms, we get

 T  
Vt = Qt + Nt Ft + FtT NtT + FtT Rt Ft + β A
et + B
e t Ft Vt+1 A
et + B
e t Ft
 
vt = βEt T T
t+1 C Vt+1 C t+1 + vt+1

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Discretion

Solution procedure:
I Make initial guess for matrices Gt+1 and Vt+1
I Calculate Gt , and Vt (which also determines Ft )
I Continue to iterate “backwards in time” until convergence

This yields the time invariant solution

ut = Fx1t
x2t = Gx1t
x1t+1 = Mx1t + C t+1
 
where M = A
e + BF
e

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Discretion

Properties of optimal policy

I Certainty equivalence
I Time consistent
I Suboptimal

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Discretion v.s. commitment
I The efficient policy frontier is useful for illustrating the
variance trade-off under commitment and discretion
I For that we first need to calculate the unconditional variances
of the output gap and inflation
I Assume without loss of generality that the covariance matrix
of t is I
I In the case of commitment, it follows from the equilibrium law
of motions for xe1t that the covariance matrix for the
predetermined variables, Σx1 is obtained by solving the
Lyapunov equation
Σx1 = MΣx1 M T + CC T ,
and from the law of motion for xe2t that the covariance matrix
for forward-looking variables is given by
Σx2 = F Σx1 F T
I Similar calculations yield the covariance matrices under
discretion
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Discretion v.s. commitment

Calibration:
I β = 0.99
I σ=1
I κ = 0.04
I =6
I θ = 2/3
I ρu = 0.8
which yields an annualized value of αx of 16 (κ/) = 0.1

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Discretion v.s. commitment
Baseline model with ut = 0.8ut−1 + εut
1800
Discretion
1600 Commitment

1400

1200
Variance output gap

αx = 0.1
1000

800

600

400

200

0
0 100 200 300 400 500 600 700 800 900
Variance inflation

37 / 41
Discretion v.s. commitment

Assume instead that the monetary policy decision is delegated to a

decision maker with loss function
 2
Lt = πt2 + αx xt2 + αi bit − bit−1

To write this model on state space form, we need to add bit to the
vector of predetermined variables, and bit − bit−1 = bit∗ − bit−1 , where
bi ∗ denotes the policy instrument, to the vector of target variables.
t

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Discretion v.s. commitment
The matrix representation of this model is
  
1 0 0 0 ut+1
0 1 0 0  it 
 b 
=

0 0 β 0 Et πt+1 
 

0 0 1/σ 1 Et xt+1
      
ρu 0 0 0 ut 0 1
 0 0 0 0 
 bit−1   1  b∗ 0
     
+ i +  ε ,

−1 0 1 −κ  πt   0  t 0 t+1
 

0 0 0 1 xt 1/σ 0

with the vector of target variables

 
given by
  u t  
0 0 1 0 0  bit−1 
 1 0 0
Yt = 0 0 0 1 0  πt , and Λ = 0 αx 0
    
0 −1 0 0 1  xt 
 
0 0 αi
bi ∗
t
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Discretion v.s. commitment
Model with αi = 0.4
1800
Discretion
1600 Commitment

1400

1200
Variance output gap

αx = 0.1
1000

800

600

400

200
αx = 0.1, αi = 0.4
0
0 100 200 300 400 500 600 700 800 900
Variance inflation

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Discretion v.s. commitment
Welfare loss as a function of αi
0.18
Discretion
Commitment
0.16

0.14
var(π) + αx var(x)

0.12

0.1

0.08

0.06
0 0.2 0.4 0.6 0.8 1
αi

41 / 41