ńņš. 1 |

Michael Woodford

Princeton University

April 1999

Revised September 2002

Preliminary and Incomplete

c Michael Woodford 2002

Contents

2 Price-Level Determination 1

1 Price-Level Determination in a Cashless Economy . . . . . . . . . . . . . . . 3

1.1 An Asset-Pricing Model with Nominal Assets . . . . . . . . . . . . . 4

1.2 A Wicksellian Policy Regime . . . . . . . . . . . . . . . . . . . . . . . 16

2 Alternative Interest-Rate Rules . . . . . . . . . . . . . . . . . . . . . . . . . 29

2.1 Exogenous Interest-Rate Targets . . . . . . . . . . . . . . . . . . . . 30

2.2 The āTaylor Principleā and Determinacy . . . . . . . . . . . . . . . . 35

2.3 Inertial Responses to Inļ¬‚ation Variation . . . . . . . . . . . . . . . . 40

3 Price-Level Determination with Monetary Frictions . . . . . . . . . . . . . . 48

3.1 A Model with Transactions Frictions . . . . . . . . . . . . . . . . . . 49

3.2 Interest-Rate Rules Reconsidered . . . . . . . . . . . . . . . . . . . . 52

3.3 A Comparison with Money-Growth Targeting . . . . . . . . . . . . . 54

3.4 Consequences of Non-Separable Utility . . . . . . . . . . . . . . . . . 60

4 Self-Fulļ¬lling Inļ¬‚ations and Deļ¬‚ations . . . . . . . . . . . . . . . . . . . . . 72

4.1 Global Multiplicity Despite Local Determinacy . . . . . . . . . . . . . 73

4.2 Policies to Prevent a Deļ¬‚ationary Trap . . . . . . . . . . . . . . . . . 82

4.3 Policies to Prevent an Inļ¬‚ationary Panic . . . . . . . . . . . . . . . . 87

1 APPENDIX TO CHAPTER 2 . . . . . . . . . . . . . . . . . . . . . . . . . . 90

1.1 Proof of Proposition 2.1 . . . . . . . . . . . . . . . . . . . . . . . . . 90

1.2 Proof of Proposition 2.2 . . . . . . . . . . . . . . . . . . . . . . . . . 91

1.3 Determinacy of Rational-Expectations Equilibrium . . . . . . . . . . 93

1.4 Proof of Proposition 2.3 . . . . . . . . . . . . . . . . . . . . . . . . . 93

1.5 Proof of Proposition 2.4 . . . . . . . . . . . . . . . . . . . . . . . . . 95

1.6 Proof of Proposition 2.5. . . . . . . . . . . . . . . . . . . . . . . . . . 97

1.7 Proof of Proposition 2.7 . . . . . . . . . . . . . . . . . . . . . . . . . 98

1.8 Proof of Proposition 2.8 . . . . . . . . . . . . . . . . . . . . . . . . . 99

1.9 Proof of Proposition 2.9. . . . . . . . . . . . . . . . . . . . . . . . . . 100

1.10 Proof of Proposition 2.10. . . . . . . . . . . . . . . . . . . . . . . . . 102

1.11 Proof of Proposition 2.11. . . . . . . . . . . . . . . . . . . . . . . . . 103

1.12 Proof of Proposition 2.12. . . . . . . . . . . . . . . . . . . . . . . . . 104

1.13 Proof of Proposition 2.13. . . . . . . . . . . . . . . . . . . . . . . . . 105

1.14 Proof of Proposition 2.14. . . . . . . . . . . . . . . . . . . . . . . . . 106

4 CONTENTS

1.15 Proof of Proposition 2.15. . . . . . . . . . . . . . . . . . . . . . . . . 106

Chapter 2

Price-Level Determination Under

Interest-Rate Rules

While virtually all central banks use a short-term nominal interest rate (typically an overnight

rate, such as the federal funds rate in the U.S.) as their instrument, and an extensive empirical

literature characterizes actual monetary policy in terms of estimated central bank āreaction

functionsā for setting such interest rates, the theoretical literature in monetary economics

has almost entirely concerned itself with the analysis of policies that are described by alter-

native (possibly state-contingent) paths for the money supply. The aim of this chapter is to

remedy this oversight by presenting a theory of price-level determination under interest-rate

rules of the sort that are often taken to describe actual central bank policies.

We shall argue that it is not necessary, in order to understand the consequences of such

rules, to ļ¬rst determine their consequences for the evolution of the money supply, and then

analyze the equivalent money-supply rule. Instead, it is possible to analyze price-level deter-

mination under such rules in terms of an explanatory framework that gives no importance

to either the evolution of the money supply or the determinants of money demand. In

this neo-Wicksellian framework, the fundamental determinants of the equilibrium price level

are instead the real factors that determine the equilibrium real rate of interest, on the one

hand, and the systematic relation between interest rates and prices established by the central

bankā™s policy rule, on the other.

We ļ¬rst expound this approach in the context of a purely cashless economy ā” one in

1

2 CHAPTER 2. PRICE-LEVEL DETERMINATION

which there are assumed to be no transactions frictions that can be reduced through the

use of money balances, and that accordingly provide a reason for holding such balances

even when they earn a rate of return that is dominated by that available on other assets.

Such a setting ā” one that is commonly assumed in ļ¬nancial economics and in purely real

models of economic ļ¬‚uctuations alike ā” allows us to display the relations that are of central

importance in the neo-Wicksellian theory in their simplest form.

At the same time, neither the usefulness nor the validity of the approach proposed here

depends on a claim that monetary frictions do not exist in actual present-day economies.

After expounding the theory for the cashless case, we show how the framework can easily be

generalized to allow for monetary frictions, modeled in one or another of the ways that are

common in monetarist models of inļ¬‚ation determination (by including real balances in the

utility function, or assuming a cash-in-advance constraint). We show in this case that equi-

librium relations continue to be obtained that are direct generalizations of the ones obtained

for the cashless economy, and that need not even imply results that are too diļ¬erent as a

quantitative matter, if the monetary frictions are parameterized in an empirically plausible

way. Hence the cashless analysis can be viewed as a useful approximation even in the case

of an economy where money balances do facilitate transactions to some extent.

In the case of an economy with transactions frictions, one can also analyze price-level

determination along traditional monetarist lines: one may view the equilibrium price level as

being determined by the expected path of the money supply, although the latter quantity is

endogenous, in the case of an interest-rate rule such as the Taylor rule, so that money, prices,

and interest rates must be simultaneously determined. In the models considered here, this

approach would not yield diļ¬erent ultimate conclusions than the neo-Wicksellian analysis,

for the system of equilibrium conditions to be solved is actually the same despite the diļ¬ering

direction of approach. Nonetheless, we shall argue that the neo-Wicksellian interpretation

of these equilibrium conditions is a particularly fruitful one, not least because it continues

to be possible in the limiting case of a cashless economy.

In this chapter, we expound the basic outlines of the neo-Wicksellian theory in the context

1. PRICE-LEVEL DETERMINATION IN A CASHLESS ECONOMY 3

of a model with ļ¬‚exible prices and an exogenous supply of goods. This allows us to address

a number of basic issues in a particularly simple context, and also allows direct comparison

of this theory with the standard quantity-theoretic approach, which, when derived from

optimizing models, is also most often expounded in a model with ļ¬‚exible prices. A more

complete development of the theory is possible only after the introduction of nominal price

rigidities in the following chapter.

1 Price-Level Determination in a Cashless Economy

We begin by considering price-level determination in an economy in which both goods mar-

kets and ļ¬nancial markets are completely frictionless: markets are perfectly competitive,

prices adjust continuously to clear markets, and there exist markets in which state-contingent

securities of any kind may be traded. Under the assumption of frictionless ļ¬nancial mar-

kets, it is natural to suppose that no āmonetaryā assets are needed in order to facilitate

transactions.

We shall suppose, however, that there exists a monetary unit of account in terms of

which prices (of both goods and ļ¬nancial assets) are quoted. This unit of account will be

deļ¬ned in terms of a claim to a certain quantity of a liability of the central bank, which may

or may not have any physical existence.1 This liability is not a claim to future payment of

anything except future units of the central-bank liability. As argued in section xx of chapter

1, the special situation of the central bank, as issuer of liabilities that promise to pay only

additional units of its own liabilities, allows the central bank to ļ¬x both the nominal interest

yield on its liabilities and the quantity of them in existence.

1

Under current U.S. arrangements, which are fairly typical, Federal Reserve notes (U.S. currency) and

Federal Reserve balances (credits in an account at the Fed, that can be used for clearing purposes and to

satisfy reserve requirements) are freely convertible into one another, and a promise to pay āa dollarā may

be discharged by transfer to the creditor (or its bank) of either of these types of ļ¬nancial claim, in the

amount of one dollar. In a cashless economy of the kind that some envision for the future, currency need no

longer exist; in such a world, the ādollarā would be deļ¬ned by a claim to a one-dollar balance at the Fed.

The fact that in such a world there would be no physical dollars (i.e., dollar bills) would not prevent the

use of dollar accounts in making payments; after all, even now, the dollar is not a claim to anything else,

and is accepted in payment only because of the expectation that it can be transferred to someone else in a

subsequent transaction.

4 CHAPTER 2. PRICE-LEVEL DETERMINATION

While we assume that there is no reason why private parties need to hold this particular

asset, or receive any beneļ¬t from doing so that would not be obtained by holding any

other similarly riskless ļ¬nancial claim denominated in terms of the same unit of account, we

assume that they choose to hold ļ¬nancial claims on the government along with privately-

issued ļ¬nancial claims. The conditions under which the private sector is willing to hold

the liabilities of the central bank, along with other government liabilities, are described by

arbitrage relations of the kind that are familiar from ļ¬nancial economics. In an equilibrium,

where these relations are satisļ¬ed, there then exists a well-deļ¬ned exchange ratio between

money and real goods and services.

In a frictionless world of this kind, base money ā” the monetary liabilities of the central

bank ā” is a perfect substitute for other riskless nominal assets of similarly short maturity,

whether these are private obligations or other (non-monetary) government obligations. As

a result, variations in the nominal size of the monetary base, due to for example to open-

market purchases of other sorts of government obligations by the central bank need have no

eļ¬ect on the prices or interest rates that represent a market equilibrium. Yet this does not

mean that in such a world, the central bank has no control over the equilibrium prices of

goods in terms of money. As we shall see, the central bankā™s policy rule is one of the key

determinants of the equilibrium price level even in a cashless economy; and it is possible,

at least in principle, for the central bank to stabilize the price level around a desired level

(or deterministic trend path) through skillful use of the tools at its disposal. But in such a

world, the crucial tool available to the central bank will not be open-market operations, but

the possibility of adjusting the interest rate paid on central-bank balances.

1.1 An Asset-Pricing Model with Nominal Assets

Consider an economy made up of a large number of identical households. The representative

household seeks to maximize the expected value of a discounted sum of period contributions

to utility of the form

ā

Ī² t u(Ct ; Ī¾t ) .

E0 (1.1)

t=0

1. PRICE-LEVEL DETERMINATION IN A CASHLESS ECONOMY 5

Here 0 < Ī² < 1 is a discount factor, and the period contribution to utility u depends upon the

level of consumption Ct of the economyā™s single good. We also allow for exogenous stochastic

disturbances Ī¾t to the period utility function, which we may think of as representing variation

in householdsā™ impatience to consume. The presence of this term represents a ļ¬rst simple

example of something of considerable importance for our general conception of the problem

facing central banks, namely, the existence of real disturbances that should be expected to

change the equilibrium real rate of return, and hence the level of nominal interest rates

required for price stability. For any given realization of Ī¾t , we assume that the period utility

function u(C; Ī¾t ) is concave and strictly increasing in C.

As noted in the introduction, we shall assume complete ļ¬nancial markets, i.e., that avail-

able ļ¬nancial assets completely span the relevant uncertainty faced by households about

future income, prices, taste shocks, and so on, so that each household faces a single in-

tertemporal budget constraint. Under the assumption of complete markets, a householdā™s

ļ¬‚ow budget constraint each period can be written in the form

Mt + Bt ā¤ Wt + Pt Yt ā’ Tt ā’ Pt Ct . (1.2)

Here Mt denotes the householdā™s nominal end-of-period balances in the distinguished ļ¬nan-

cial asset (the monetary base) which represents the economyā™s unit of account, Bt represents

the nominal value (in terms of this unit of account) of the householdā™s end-of-period portfo-

lio of all other ļ¬nancial assets (whether privately issued or claims on the government), Wt

represents beginning-of-period ļ¬nancial wealth (now counting the monetary base along with

other assets), Yt is an exogenous (possibly stochastic) endowment of the single good, Pt is

the price of the good in terms of the monetary unit, and Tt represents net (nominal) tax

collections by the government. The constraint says that total end-of-period ļ¬nancial assets

(money plus bonds) can be worth no more than the value of ļ¬nancial wealth brought into

the period, plus non-ļ¬nancial income during the period net of taxes and the value of con-

sumption spending. Interest income is not written explicitly in (1.2), because it is assumed

to accrue between the discrete dates at which decisions are made; thus Wt already includes

6 CHAPTER 2. PRICE-LEVEL DETERMINATION

the interest earned on bonds held at the end of period t ā’ 1.2

It is important to note that in (1.2), Bt does not refer to the quantity held of some

single type of bond; as we assume complete markets, households must be able, at least

in principle, to hold any of a wide selection of instruments with diļ¬erent state-contingent

returns. We need not, however, introduce any notation for the particular types of ļ¬nancial

instruments that are traded. (This is one of the conveniences of the assumption of complete

markets.) Since any pattern of state-contingent payoļ¬s in the future that a household may

desire can be arranged (for the appropriate price), we can write the householdā™s consumption

planning and wealth-accumulation problems without any explicit reference to the quantities

that it holds of particular assets; and if there are redundant assets, there will not actually

be determinate demands for individual assets (our assumption in the case of the monetary

base). We distinguish the householdā™s holdings of the monetary base from the rest of its

end-of-period portfolio, however, in order to allow us to explicitly discuss the central bankā™s

supply of this asset and the interest paid on it.

In the proposed notation, we may simply represent the householdā™s portfolio choice as a

choice of the state-contingent value At+1 of its non-monetary portfolio at the beginning of

the next period. Total beginning-of-period wealth in the following period is then given by

Wt+1 = (1 + im )Mt + At+1 , (1.3)

t

where im is the nominal interest rate paid on money balances held at the end of period t.

t

Note that this implies that Wt+1 , as a function of the state of the world realized in period

t + 1, is determined by decisions made in period t; thus Wt is a predetermined state variable

in (1.2).

At the time of the portfolio decision, At+1 is a random variable, whose value will de-

pend upon the state of the world in period t + 1. But the household chooses the complete

2

See equation (1.6) below. Though we often refer to a succession of āperiodsā, as is common in the

macroeconomic literature, our models are formally ones in which trading occurs at a sequence of discrete

points in time. References to ābeginning-of-periodā and āend-of-periodā portfolios are simply notation to

keep track of the eļ¬ects of trades, not references to diļ¬erent points in time, between which interest may

accrue.

1. PRICE-LEVEL DETERMINATION IN A CASHLESS ECONOMY 7

speciļ¬cation of this random variable, its value in every possible state. The absence of arbi-

trage opportunities (a necessary requirement for equilibrium) then requires that there exist

a (unique) stochastic discount factor (or asset pricing kernel) Qt,t+1 with the property that

the price in period t of any bond portfolio with random value At+1 in the following period

is given by

Bt = Et [Qt,t+1 At+1 ]. (1.4)

(As of date t, Qt,t+1 remains a random variable; and Et refers to the expectation conditional

upon the state of the world at date t.) In terms of this discount factor, the riskless short-term

(one-period) nominal interest rate it corresponds to the solution to the equation

1

= Et [Qt,t+1 ]. (1.5)

1 + it

Note that if it happens that the representative household chooses to hold a purely riskless

portfolio (in nominal terms), so that At+1 is perfectly forecastable at date t, (1.4) states

simply that At+1 = (1 + it )Bt . Substituting this into (1.3), and the resulting expression for

Wt into (1.2), which holds with equality in equilibrium, we obtain the familiar diļ¬erence

equation

Mt + Bt = (1 + im )Mtā’1 + (1 + itā’1 )Btā’1 + Pt Yt ā’ Tt ā’ Pt Ct (1.6)

t

for the evolution of Bt . This will actually be an equilibrium condition in the case that the

government issues only riskless one-period debt; but it is still important, even in that case, to

recognize that an individual householdā™s budget constraint allows it the possibility of shifting

wealth across states of the world in other ways.3

More generally, then, equations (1.2), (1.3) and (1.4) together give a complete description

of the householdā™s ļ¬‚ow budget constraint. Using (1.3) and (1.4) to eliminate Bt from (1.2),

3

Condition (1.6) actually represents the correct ļ¬‚ow budget constraint if we assume such radically incom-

plete markets that households can neither borrow nor lend except in terms of the single instrument assumed

to be issued by the government. This case of a single traded asset is often considered in the literature on

consumption theory (see, e.g., Obstfeld and Rogoļ¬, 1996, sec. 2.3). And in the present context, with identi-

cal households, it makes no real diļ¬erence what we assume about the number of ļ¬nancial markets that are

open. However, the characterization of optimal household plans is simplest in the case of complete markets,

and the introduction of market valuations for arbitrary random income streams will prove useful, in the next

chapter, when we need to consider the optimal pricing decisions of ļ¬rms.

8 CHAPTER 2. PRICE-LEVEL DETERMINATION

the constraint can alternatively be written

(1 ā’ Et Qt,t+1 (1 + im ))Mt + Et [Qt,t+1 Wt+1 ] ā¤ Wt + [Pt Yt ā’ Tt ā’ Pt Ct ].

t

Using (1.5), this becomes

Pt Ct + āt Mt + Et [Qt,t+1 Wt+1 ] ā¤ Wt + [Pt Yt ā’ Tt ]. (1.7)

where

it ā’ im

t

āt ā” . (1.8)

1 + it

It is clear from this version that the interest-rate diļ¬erential āt between non-monetary

and monetary assets represents the opportunity cost of holding wealth in monetary form.

Given its planned state-contingent wealth Wt+1 at the beginning of the following period, the

household can choose any values Ct , Mt ā„ 0 that satisfy (1.7).4

A complete description of the householdā™s budget constraints requires that we also specify

a limit on borrowing, to prevent āPonzi schemesā of the kind that would otherwise be

consistent with the inļ¬nite sequence of ļ¬‚ow budget constraints in an inļ¬nite-horizon model.

In the spirit of our assumption of perfectly frictionless ļ¬nancial markets, it is natural to

suppose that there is no obstacle to borrowing against after-tax endowment income that

may be anticipated (even if in only some states of the world) at any future date. The

implied constraint is then that the household must hold a net portfolio at the end of period

t (possibly including issuance of some securities, in order to borrow against future income)

such that the wealth Wt+1 transferred into the next period satisļ¬es the bound

ā

Wt+1 ā„ ā’ Et+1 [Qt+1,T (PT YT ā’ TT )] (1.9)

T =t+1

with certainty, i.e., in each state of the world that may be reached in period t + 1. Here the

general stochastic discount factor Qt,T for discounting (nominal) income in period T back to

4

We assume that money balances must be non-negative because this asset is deļ¬ned as a liability of the

central bank, that accordingly cannot be issued by any other parties, even though (under our assumption

of complete markets) private securities are issued that are equivalent in terms of their state-contingent

payouts. This non-negativity constraint is another reason to single out this asset from the others in writing

the householdā™s budget constraints; for we assume no short-sale constraints in the case of any other securities

in our model with frictionless ļ¬nancial markets.

1. PRICE-LEVEL DETERMINATION IN A CASHLESS ECONOMY 9

an earlier period t is deļ¬ned by

T

Qt,T ā” Qsā’1,s .

s=t+1

(We also use the notation Qt,t ā” 1.) Condition (1.9) then says that a household cannot plan

to be indebted in any state in an amount greater than the present value of all subsequent

after-tax non-ļ¬nancial income.

The entire inļ¬nite sequence of ļ¬‚ow budget constraints (1.7) and borrowing limits (1.9)

are equivalent to a single intertemporal (or lifetime) budget constraint for the household. We

note ļ¬rst of all that unless the present value on the right-hand side of (1.9) is well-deļ¬ned

(i.e., the inļ¬nite sum converges), the household has no budget constraint: Ponzi schemes

are possible, hence unlimited consumption is aļ¬ordable. Furthermore, if the present value is

inļ¬nite looking forward from any state of the world, at any date, unbounded consumption

is possible not only at that date and in all other states (including along histories under

which the state in question never occurs); for with complete markets, it is possible to borrow

against that state to ļ¬nance unbounded consumption in any other state.

We may thus restrict attention to the case in which Ponzi schemes are not possible,

because

ā

Et [Qt,T (PT yT ā’ TT )] < ā (1.10)

T =t

at all times.5 The budget constraint is also undeļ¬ned unless interest rates satisfy the lower

bound

it ā„ im (1.11)

t

at all times. For otherwise, an arbitrage opportunity exists; a household can ļ¬nance unlim-

ited consumption by shorting riskless one-period bonds (i.e., borrowing at the short riskless

rate, assumed to be negative) and using the proceeds partly to hold cash suļ¬cient to repur-

chase the bonds (repay its debt) a period later and partly to ļ¬nance additional consumption.

Because utility is assumed to be strictly increasing in consumption, such an operation con-

5

Throughout, it should be understood that when we say that such a relation holds āat all times,ā this

also means in all possible states of the world at each date.

10 CHAPTER 2. PRICE-LEVEL DETERMINATION

tinues to increase utility no much matter how much it may be engaged in. Hence we may

also restrict attention to the case in which (1.11) holds at all times.

We are then able to establish that the inļ¬nite sequence of ļ¬‚ow budget constraints (1.7)

are equivalent to a single intertemporal budget constraint.

Proposition 2.1. Consider positive-valued stochastic processes {Pt , Qt,T } satisfying

(1.10) and (1.11) at all dates, and let {Ct , Mt } be non-negative-valued processes representing

a possible consumption and money-accumulation plan for the household. Then there exists

a speciļ¬cation of the householdā™s portfolio plan at each date satisfying both the ļ¬‚ow budget

constraint (1.7) and the borrowing limit (1.9) at each date, if and only if the plans {Ct , Mt }

satisfy the constraint

ā ā

E0 Q0,t [Pt Ct + āt Mt ] ā¤ W0 + E0 Q0,t [Pt Yt ā’ Tt ]. (1.12)

t=0 t=0

The proof is given in the appendix. Note that the intertemporal budget constraint states

simply that the present value of the householdā™s planned consumption over the entire indef-

inite future, plus the cost to it of its planned money holdings, must not exceed its initial

ļ¬nancial wealth plus the present value of its expected after-tax income from sources other

than ļ¬nancial assets. One can also show (see the proof in the appendix) that the householdā™s

continuation plan, looking forward from any date t (i.e., its plan for dates T ā„ t, in all of

the states that remain possible given the state of the world at date t), must satisfy the

corresponding intertemporal budget constraint

ā ā

Et Qt,s [Ps cs + ās Ms ] ā¤ Wt + Et Qt,s [Ps ys ā’ Ts ]. (1.13)

s=t s=t

The householdā™s optimization problem is then to choose processes Ct , Mt ā„ 0 for all

dates t ā„ 0, satisfying (1.12) given its initial wealth W0 and the goods prices and asset

prices (indicated by the stochastic discount factors Qt,t+1 ) that it expects to face, so as to

maximize (1.1). Given an optimal choice of these processes, an optimal path for Wt may

1. PRICE-LEVEL DETERMINATION IN A CASHLESS ECONOMY 11

be constructed as in the proof of Proposition 2.1. Given a stochastic process for Wt+1 , the

implied processes for At+1 and for Bt are given by (1.3) and (1.4).

Because this is essentially a standard concave optimization problem subject to a single

budget constraint, necessary and suļ¬cient conditions for household optimization are easily

given. First of all, (1.10) and (1.11) must hold at all times, since otherwise no optimal plan

exists (as more consumption is always possible). Second, since in the cashless economy there

is no non-pecuniary beneļ¬t to holding money balances, household optimization requires that

either

Mt = 0 (1.14)

or

it = im (1.15)

t

at each date and in each possible state (though which condition obtains may diļ¬er across

dates and across states).

Third, by equating marginal rates of substitution to relative prices, we obtain the ļ¬rst-

order conditions

uc (Ct ; Ī¾t ) Ī² Pt

= . (1.16)

uc (Ct+1 ; Ī¾t+1 ) Qt,t+1 Pt+1

Here Uc is the partial derivative of U with respect to the level of consumption. This condition

must hold for each possible state at each date t ā„ 0, and for each possible state that may

occur at date t + 1, given the state that has occurred at date t. (Qt,t+1 indicates the value of

the discount factor in a particular state at date t + 1.) Using (1.5), condition (1.16) implies

that the short-term nominal interest rate must satisfy

ā’1

uc (Ct+1 ; Ī¾t+1 ) Pt

ā’1

1 + it = Ī² Et (1.17)

uc (Ct , ; Ī¾t ) Pt+1

at each date.

Finally, optimization requires that the household exhaust its intertemporal budget con-

straint; that is, (1.13) must hold as an equality at each date. Equivalently, the ļ¬‚ow budget

constraint (1.2) must hold as an equality at each date, and in addition, the householdā™s

12 CHAPTER 2. PRICE-LEVEL DETERMINATION

wealth accumulation must satisfy the transversality condition

lim Et [Qt,T WT ] = 0. (1.18)

T ā’ā

(Condition (1.13), stated as a strict equality, implies both that (1.2) must hold as a strict

equality at each date T ā„ t, and that (1.18) must hold. Conversely, the latter set of conditions

imply that (1.13) holds with strict equality, looking forward from date t.) Finally, given that

(1.13) must hold with strict equality, condition (1.10) may equivalently be written

ā

Et Qt,T [PT CT + āT MT ] < ā. (1.19)

T =t

We thus obtain a set of conditions ā” (1.2) as a strict equality; the requirement that either

(1.14) or (1.15) hold with equality, in addition to the inequality conditions (1.11) and Mt ā„ 0;

(1.16); (1.18); and (1.19) ā” that must hold at all times in order for the representative

householdā™s actions to be optimal. At the same time, one can show that this set of conditions

suļ¬ces for optimality as well.

We may now state the complete set of conditions for a rational expectations (or intertem-

poral) equilibrium in this model. In addition to the conditions just stated for household

optimization, markets must clear at all dates. This means that household demands must

satisfy

Mt = Mts , At+1 = As

Ct = Yt , t+1

at all dates. Here Mts refers to the supply of base money by the central bank, which we

assume to be positive at all dates. As refers to the aggregate value at the beginning of

t+1

period t + 1 of government bonds in the hands of the public at the end of period t . (In

s s

general, it would not suļ¬ce for bond-market clearing to require that Bt = Bt , where Bt

denotes the market value of government bonds outstanding at the end of period t, as this

could allow households to demand a portfolio with diļ¬erent state-contingent payoļ¬s than

the aggregate supply of government bonds.) If we specify the supply of government bonds

s

in more primitive terms by specifying the variables {Bt,t+j }, where for each date t and each

s

j ā„ 1, Bt,t+j denotes the total (nominal) coupons that the government promises to pay at

1. PRICE-LEVEL DETERMINATION IN A CASHLESS ECONOMY 13

date t + j on bonds that are outstanding at the end of period t, then

ā

As s

ā” Et+1 [Qt+1,t+j Bt,t+j ]

t+1

j=1

in each possible state that may be reached at date t + 1. Finally, note that we abstract here

from government purchases of real goods and services (though the model is extended below

to allow for them).

Given that Mts > 0, market-clearing implies that (1.14) cannot hold, and hence that

(1.15) must hold at all times. Substituting the market-clearing conditions into conditions

(1.16) ā“ (1.17) for household optimization, we obtain equilibrium conditions

uc (Yt ; Ī¾t ) Ī² Pt

= , (1.20)

uc (Yt+1 ; Ī¾t+1 ) Qt,t+1 Pt+1

ā’1

uc (Yt+1 ; Ī¾t+1 ) Pt

1 + it = Ī² ā’1 Et (1.21)

uc (Yt ; Ī¾t ) Pt+1

for each date. Note that the latter relation takes the form of a āFisher equationā for the nom-

inal interest rate, where the intertemporal marginal rate of substitution of the representative

household plays the role of the real-interest factor.

Finally, substituting our solution (1.20) for the stochastic discount factor into (1.18) and

(1.19), the latter conditions take the form

lim Ī² T Et [uc (Yt ; Ī¾T )WT /PT ] = 0,

s

(1.22)

T ā’ā

ā

Ī² T Et [uc (Yt ; Ī¾T )YT ] < ā. (1.23)

T =t

s

(Here we have also used the market-clearing conditions to equate WT with WT ā” (1 +

imā’1 )MT ā’1 + As , the total supply of nominal claims on the government at the beginning

s

T T

of period T , and (1.15) to substitute for the factor āT in (1.19).) A rational-expectations

equilibrium is then a collection of processes that satisfy (1.15), (1.21), (1.22) and (1.23) at

all dates t ā„ 0.

The transversality condition (1.22) can equivalently be written in a possibly more familiar

form, in terms of the end-of-period value of total government liabilities, Dt ā” Mts + Bt .

s

14 CHAPTER 2. PRICE-LEVEL DETERMINATION

Proposition 2.2. Let assets be priced by a system of stochastic discount factors that

satisfy (1.20), and consider processes {Pt , it , im , Mts , Wts } that satisfy (1.15), (1.21), and

t

(1.23) at all dates, given the exogenous processes {Yt , Ī¾t }. Then these processes satisfy

(1.22) as well if and only if they satisfy

lim Ī² T Et [uc (YT ; Ī¾T )DT /PT ] = 0. (1.24)

T ā’ā

The proof is given in the appendix. It follows that we can equivalently deļ¬ne equilibrium as

follows.

Definition. A rational-expectations equilibrium of the cashless economy is a pair of

processes {Pt , it } that satisfy (1.15), (1.21), (1.23), and (1.24) at all dates t ā„ 0, given the

exogenous processes {Yt , Ī¾t }, and evolution of the variables {im , Mts , Dt } consistent with the

t

monetary-ļ¬scal policy regime.

This latter formulation is especially useful in that it allows us to specify ļ¬scal policy in

terms of restrictions on the evolution of the total government liabilities, or alternatively,

restrictions on the path of the conventional government budget deļ¬cit.

Note that we need not include the additional equilibrium condition (1.20) in our deļ¬-

nition of rational-expectations equilibrium, if we are interested only in the determination

of equilibrium prices and interest rates. (The additional condition must be appended to

our system, of course, if we are interested in other equilibrium asset prices.) Nor is there

any additional equilibrium condition corresponding to the requirement that (1.2) hold with

equality; this condition is necessarily satisļ¬ed (when we substitute the market-clearing con-

ditions) as long as the supplies of government liabilities evolve in accordance with the ļ¬‚ow

government budget constraint

Et [Qt,t+1 Wt+1 ] = Wts ā’ Tt ā’ āt Mts .

s

(1.25)

We shall assume that the monetary-ļ¬scal policy regime satisļ¬es this constraint at all times.

We then have a system of two equalities at each date, (1.15) and (1.21), to determine the two

1. PRICE-LEVEL DETERMINATION IN A CASHLESS ECONOMY 15

endogenous variables Pt and it , together with the bounds (1.23) and (1.24) that the solution

must satisfy.

Our notation thus far allows only for ļ¬scal policies consisting of taxes or transfers. But the

framework above is easily extended to allow for government purchases of goods and services

as well, without any material change being required in the above equilibrium conditions. Let

government purchases of the single good in period t be denoted Gt , and suppose that {Gt }

is an exogenous process, such that Gt < Yt at all dates.6 Market clearing then requires that

Ct + Gt = Yt at all dates. Substitution of this relation into the conditions for optimization

by the representative household then leads to equilibrium conditions such as

ā’1

uc (Yt+1 ā’ Gt+1 ; Ī¾t+1 ) Pt

1 + it = Ī² ā’1 Et , (1.26)

uc (Yt ā’ Gt ; Ī¾t ) Pt+1

generalizing (1.21).

We note that (1.26) is obtained from the previous equation (1.21) by replacing uc (Yt ; Ī¾t )

by uc (Yt ā’ Gt ; Ī¾t ) each time it occurs. The same is true for the other equilibrium conditions

(1.20), (1.23) and (1.24) as well. Alternatively, we obtain the equilibrium conditions for the

general case by replacing the ādirectā utility function u(Ct ; Ī¾t ) throughout our calculations

by the āindirectā utility

Ė

u(Yt ; Ī¾t ) ā” u(Yt ā’ Gt ; Ī¾t ), )

Ė (1.27)

indicating the utility ļ¬‚ow to the representative household as a function of its ātotal demandā

for resources Yt , where total demand adds the resources consumed by the government on the

householdā™s behalf (its per-capita share of government purchases) to the householdā™s private

Ė

consumption.7 In this indirect utility function, Ī¾t indicates a vector of disturbances that

includes both Gt and the taste shock Ī¾t .

6

One might, of course, also consider ļ¬scal policies under which Gt is endogenously determined, for example

as the solution to some welfare-maximization problem of the governmentā™s. In the present study, however,

we shall assume that government purchases are given exogenously. We allow for endogeneity of the level

of net tax collections, as for example in the next section, and this is some importance for our theory of

price-level determination. See section xx of chapter 4 for further discussion.

7

Here we use the same notation Yt for a choice variable of the household as has previously been used

for the exogenous supply of goods. In fact, in the model with endogenous output presented in chapter 4,

equilibrium conditions such as (1.27) continue to apply, but with Yt referring to aggregate demand, and not

to any exogenously given supply of goods.

16 CHAPTER 2. PRICE-LEVEL DETERMINATION

The householdā™s problem can then be written as one of choosing the state-contingent

evolution of total demand to maximize its expected discounted ļ¬‚ow of indirect utility subject

to an intertemporal budget constraint of the form (1.12), if Ct in this constraint is taken to

refer to total demand, and Tt to the primary government budget surplus (tax collections in

excess of government spending).8 In this case, we can derive exactly the same equilibrium

conditions as were obtained earlier, except that the function u is everywhere replaced by u.

Ė

Hence variations in the level of government purchases Gt have exactly the same eļ¬ect as the

Ė

taste shock Ī¾t ; they are simply another source of exogenous variations in the relation uc (Yt ; Ī¾t )

Ė

between the marginal utility of income to the representative household and aggregate output,

and hence of variations in the equilibrium real rate of interest.

1.2 A Wicksellian Policy Regime

We now oļ¬er a simple example of a complete speciļ¬cation of monetary and ļ¬scal policy rules

for a cashless economy, and consider the determinants of the equilibrium path of the money

price of goods under such a regime. Note that, as a consequence of the forward-looking

character of householdsā™ asset accumulation problems, the determination of equilibrium at

any point in time requires that we specify how policy is expected to be conducted into the

indeļ¬nite future, and in all possible future states. This is one reason for our speciļ¬cation

of government policy in terms of systematic rules for the determination of both the central

bankā™s actions and the governmentā™s budget.

Our speciļ¬cation of monetary policy will be in the spirit of Wicksellā™s (1898, 1907) pro-

posed rule. As discussed in the previous chapter, this rule can be expressed in terms of a

formula for the central bankā™s interest-rate operating target. We shall also explicitly specify

the way in which the central bank adjusts the two instruments at its disposal ā” the nominal

value of the monetary base Mts , on the one hand, and the interest rate im paid on base money

t

8

The deļ¬nition of equilibrium that results from this formulation of the householdā™s problem is equivalent

to the standard one, subject to the proviso that the processes {Gt , Yt , Ī¾t } are such that the present value of

government purchases is ļ¬nite. Technically, one can imagine an equilibrium in which the present value of per

capita output is not ļ¬nite, though the present value of the resources left for the private sector to consume is

ļ¬nite. But this special case is of little interest and is ignored here.

1. PRICE-LEVEL DETERMINATION IN A CASHLESS ECONOMY 17

on the other ā” in order to achieve its operating target. In a world with monetary frictions

(discussed below in section xx), it is possible to use either of these instruments to aļ¬ect

the level of short-term nominal interest rates, and as discussed in chapter 1, actual central

banks diļ¬er in the extent to which they use these two means to implement policy (though

almost all central banks formulate policy in terms of an interest-rate operating target). In

the cashless economy described above, however, changes in the quantity of base money (for

example, through open-market purchases of government securities) have no consequences for

the equilibrium determination of interest rates or other variables. (Note that Mts does not

appear in any of the equilibrium conditions obtained at the end of the previous section.)

Hence policy targets must be implemented exclusively through adjustment of the interest

paid on base money.

Speciļ¬cally, we assume a regime under which the interest paid on base money is equal

at all times to the central bankā™s current interest-rate target, determined in response to

the bankā™s assessment of current aggregate conditions. Such a system would resemble the

āchannel systemsā described in chapter 1, under which the interest paid on central-bank

balances is equal to the target rate minus a ļ¬xed spread; here the spread is assumed to be

zero, since in equilibrium, the market interest rate it will actually equal im , and not im plus

t t

any positive spread. It is true that current channel systems pay interest only on central-bank

clearing balances, and not on currency. But we can interpret the regime analyzed here to

have this property as well; in a cashless world, this would simply mean that currency would

not be held in equilibrium (any initially existing currency would be promptly deposited with

the central bank in an interest-earning account), so that ābase moneyā Mts would correspond

to the supply of clearing balances.

Under a Wicksellian rule for the interest-rate target, the interest rate paid on central-bank

balances equals

im = Ļ(Pt /Ptā— ; Ī½t ) (1.28)

t

where Ptā— > 0 deļ¬nes a target path for the price level, Ī½t is an additional possible exogenous

random disturbance to the policy rule (or to its implementation), and Ļ(Ā·; Ī½) is a non-

18 CHAPTER 2. PRICE-LEVEL DETERMINATION

negative-valued, non-decreasing function for each possible value of the disturbance Ī½.9

Here the function Ļ indicates the rule used by the central bank to sets its operating target,

while equation (1.28) indicates the way in which the rule is implemented. The inclusion of a

time-varying price-level target Ptā— allows us to treat the case of a rule that seeks to stabilize

the price level around a modestly growing trend path ā” say, a rule that provides for one

or two percent inļ¬‚ation per year, perhaps to compensate for bias in the price index that

is targeted ā” rather than necessarily assuming a constant price level target, as Wicksell

did. The inclusion of the random disturbance Ī½t allows us to consider the eļ¬ects of random

variations in policy, or in its implementation, that we may not wish to model as changes in

the target price level itself. This includes the possibility that the central bank may respond

to output variations as well as the path of prices, as called for by the Taylor (1993) rule;

or that the central bank may respond to perceived variation in the equilibrium real rate of

return. (In the present model, both output and the equilibrium real interest rate are purely

exogenous; hence systematic responses to these variables can be modeled by the inclusion of

an exogenous disturbance term in the policy rule.)

We also need to specify the rule by which the evolution of the monetary base is deter-

mined. Here we assume simply that {Mts } is an exogenous, positive-valued sequence. The

logic of the Wicksellian regime requires no variation over time in the supply of base money

at all; however, we allow for possible variation over time in the monetary base, in order to

analyze the equilibrium consequences of this kind of policy action.

Finally, ļ¬scal policy is speciļ¬ed by a rule for the evolution of the total supply of gov-

ernment liabilities {Dt }, and by a speciļ¬cation of the composition of government liabilities

(debt-management policy) at each point in time. For simplicity, we let {Dt } be an exogenous

9

The function is assumed to be non-negative on the ground that it is not possible for the central bank

to drive nominal interest rates to negative levels. We assume that, as under typical current arrangements,

the holders of central-bank balances have the right to ask for currency in exchange for such balances at any

time, and that it is infeasible to pay negative interest on currency. Hence an attempt to pay negative interest

on central-bank balances would lead to zero demand for such balances, and a market overnight interest rate

of zero (the rate available on currency), rather than a negative overnight interest rate. The assumed non-

negativity of the function requires that Ļ(P/P ā— ; Ī½) not be an exactly linear function of log(P/P ā— ), though

we make use a local log-linear approximation to the function below.

1. PRICE-LEVEL DETERMINATION IN A CASHLESS ECONOMY 19

process. One simple example of such a ļ¬scal rule would be a balanced-budget rule of the

kind analyzed by Schmitt-GrohĀ“ and Uribe (2000), where āDt = 0 each period; another

e

would be a policy under which no government bonds are ever issued, so that Dt = Mts each

period. We also simplify by assuming that all government debt consists entirely of riskless

s

one-period nominal bonds. The variable Bt then indicates the supply of such bonds at the

end of period t, in terms of their nominal value at the time of issuance (rather than maturity).

The implied rule for net tax collections Tt is then given by

s

Tt = (1 + itā’1 )(Dtā’1 ā’ ātā’1 Mtā’1 ) ā’ Dt , (1.29)

using the fact that As = (1 + itā’1 )Btā’1 ) = (1 + itā’1 )(Dtā’1 ā’ Mtā’1 ).

s s

t

A rational-expectations equilibrium is then a set of processes {Pt , it , im } that satisfy

t

(1.15), (1.21), (1.23), (1.24), and (1.28) at all dates t ā„ 0, given the exogenous processes

{Yt , Ī¾t , Mts , Dt }.10 Using (1.15) to eliminate im in (1.28), we obtain

t

it = Ļ(Pt /Ptā— ; Ī½t ), (1.30)

as an equilibrium condition linking the paths of interest rates and prices. (Note that this

equation directly expresses the interest-rate rule that the central bank implements through

its adjustment of the interest rate paid on base money.) We note furthermore that condition

(1.23) does not involve any endogenous variables, and thus plays no role in equilibrium

determination. We assume processes {Yt , Ī¾t } that satisfy this condition; having done so, we

can drop (1.23) from our list of requirements for equilibrium. We can thus identify rational-

expectations equilibrium with a set of processes {Pt , it } that satisfy (1.21), (1.24) and (1.30)

each period.

We are interested not only in whether a solution to this system of equilibrium conditions

exists, but in whether these relations suļ¬ce to uniquely determine the equilibrium paths of

interest rates and prices. The question of the determinacy of equilibrium is a preliminary,

more basic issue, before we can hope to address the question of what factors aļ¬ect the

10

In the case that we allow for government purchases, one should replace u by u in each equation, and Ī¾t

Ė

Ėt .

by Ī¾

20 CHAPTER 2. PRICE-LEVEL DETERMINATION

equilibrium price level and how they aļ¬ect it. And there are obvious reasons to worry about

determinacy under the kind of regime just described. In the celebrated analysis of Sargent

and Wallace (1975), interest-rate rules as such are to be avoided, on the ground that they

result in indeterminacy of the equilibrium price level (and hence, in their model, of the

equilibrium paths of real variables as well). And it is also often worried that in a cashless

economy, there should be nothing to pin down the equilibrium price level, given that there

is in such an environment no determinate demand for the monetary base; this is sometimes

argued to be an important reason to head oļ¬ ļ¬nancial innovations that could lead to this

kind of world (e.g., Friedman, 2000).

A general analysis of the existence and uniqueness of solutions to our system of equa-

tions, for arbitrary monetary and ļ¬scal policy rules, is beyond the scope of this study. We

shall instead address here, and in most of this study, a more limited question, namely the

local determinacy of equilibrium, in the case of policies that involve only small ļ¬‚uctuations

over time in the monetary policy rule, and assuming that other exogenous disturbances are

similarly small. By local determinacy we mean the question of whether there is a unique

equilibrium within a suļ¬ciently small neighborhood of certain paths for the endogenous

variables. If so, this equilibrium is at least locally unique, and such local uniqueness makes

possible a well-deļ¬ned ācomparative staticsā analysis of the eļ¬ects of small disturbances or

parameter changes.11 In fact, we shall analyze the eļ¬ects of small ļ¬‚uctuations in the price-

level target, and other small disturbances, through exactly such a consideration of how the

steady-state equilibrium associated with steady trend growth of the price-level target and

zero disturbances is perturbed by small stochastic variations in the exogenous variables.

An advantage of restricting our attention to this question is that it can be addressed using

purely linear methods; we analyze a log-linear approximation to the structural equations

derived above, and characterize the (bounded) log-linear solutions to these equations. This

way of characterizing both the important structural relations implied by our model, and the

11

See section xx of the appendix for further general discussion of the issue of local determinacy and of the

methods used in this section to analyze it.

1. PRICE-LEVEL DETERMINATION IN A CASHLESS ECONOMY 21

predicted equilibrium evolution of economic time series under alternative policies, is useful

not only because of its tractability, but because of the ubiquity of linear time series models

in empirical studies. Our approach will thus allow a direct mapping between the predictions

of optimizing models of economic behavior and the kinds of structural models and data

characterizations already used in quantitative monetary policy analysis. This will facilitate

both evaluation of the empirical adequacy of the optimizing models, and productive dialogue

between optimization-based and more traditional approaches to policy evaluation.

Furthermore, such an analysis corresponds reasonably closely to the way that the deter-

minacy of rational expectations equilibrium is considered by Sargent and Wallace (1975).

That paper assumes a log-linear model, and considers the uniqueness of non-explosive solu-

tions to the log-linear structural equations. Our method will be essentially the same, except

that the log-linear structural equations can be justiļ¬ed as a log-linear approximation to exact

relations derived from an explicit intertemporal general equilibrium model, and that we shall

be more explicit about the class of solutions to be considered. Thus the analysis here suļ¬ces

to address the particular issue relating to determinacy of equilibrium under interest-rate

rules raised by Sargent and Wallace.12

We begin by characterizing the steady state near which we shall look for other solutions.

ĀÆ

Consider an environment in which Yt = Y > 0 and Ī¾t = 0 at all times. Let us assume a

policy regime under which the price-level target grows at the constant rate

ā—

Pt+1 ĀÆ

=Ī >Ī²

ā—

Pt

ā—

at all dates (with some initial P0 > 0), Ī½t = 0 at all dates, and suppose that the function Ļ

satisļ¬es

ĀÆ

Ī

1 + Ļ(1; 0) = ,

Ī²

so that the policy rule is consistent with the assumed target path for prices. Let us also

12

In chapter 4, we consider an extension of the model in this chapter which is essentially a rational-

expectations IS-LM model, though not identical in structure to the one analyzed by Sargent and Wallace

(1975). The determinacy of equilibrium under alternative policy rules is taken up again in that chapter.

22 CHAPTER 2. PRICE-LEVEL DETERMINATION

assume a ļ¬scal rule under which

ĀÆ

Dt+1 Ī

= Ī³D <

Dt Ī²

at all dates (given initial government liabilities D0 > 0), and an open-market policy under

which {Mts } is an arbitrary sequence, satisfying

0 < Mts < Dt (1.31)

at all times. Under such a policy regime, we easily observe that the paths

ĀÆ

Ī ā’Ī²

Ptā— ,

Pt = it = ĀÆ ā”

Ä± >0

Ī²

for all t represent a rational-expectations equilibrium.

Next, let us consider an environment in which there are only small ļ¬‚uctuations in the

exogenous variables Yt , Pt+1 /Ptā— , Ī½t , and Dt+1 /Dt around the constant values speciļ¬ed in the

ā—

previous paragraph. (Speciļ¬cally, we suppose that each of these variables remains forever

within a bounded interval containing a neighborhood of the steady-state value.) We also

continue to assume that the process {Mts } satisļ¬es the bounds (1.31). We wish to look for

rational-expectations equilibria in which the endogenous variables it and Pt /Ptā— similarly

remain forever within certain neighborhoods of their steady-state values. In this case, condi-

tion (1.24) is necessarily satisļ¬ed (for any tight enough bounds on the allowable variation in

the variables listed above); thus we need only consider the (local) existence and uniqueness

of solutions to the system of equations consisting of (1.21) and (1.30).

In the case of tight enough bounds on the variations that we consider in these variables,

it suļ¬ces that we consider the bounded solutions to a system consisting of log-linear approx-

imations to conditions (1.21) and (1.30).13 For the sake of simplicity (and continuity with

the assumptions made in more complex examples in the next two chapters), we shall specify

ĀÆ

that the steady state around which we log-linearize is one in which Ī = 1, so that there is

zero inļ¬‚ation. (This does not require that we only analyze policies under which there is no

13

As is further explained in the appendix, this amounts to using the inverse function theorem to demon-

strate local uniqueness of the solution to our system of equilibrium conditions, and using the implicit function

theorem to give a log-linear local approximation to the solution.

1. PRICE-LEVEL DETERMINATION IN A CASHLESS ECONOMY 23

trend growth in the price-level target: it only requires that the target inļ¬‚ation rate is never

very large.)

A log-linear approximation to (1.21) is then given by14

Ėt = rt + Et Ļt+1 ,

Ä± Ė (1.32)

where

1 + it Pt

Ėt ā” log

Ä± , Ļt ā” log .

1 +ĀÆÄ± Ptā’1

Here the (percentage deviation in the) ex-ante short-term equilibrium real rate of return rt

Ė

is an exogenous process given by

Ė Ė

rt = Ļ ā’1 [Et (Yt+1 ā’ gt+1 ) ā’ (Yt ā’ gt )],

Ė (1.33)

where the constant coeļ¬cient

uc

Ļā”ā’ ĀÆ >0

ucc Y

measures the intertemporal elasticity of substitution in private spending, and the disturbance

term

ucĪ¾

gt ā” ā’ ĀÆ Ī¾t

Y ucc

indicates the percentage increase in output required to keep the marginal utility of income

constant, given the change that has occurred in the impatience to consume.

In the case of the model extended to allow for government purchases, equations (1.32)

ĀÆĀÆ

ā“ (1.33) still apply, under the alternative deļ¬nitions Ļ ā” sC ĻC , where sC ā” C/Y is the

steady-state share of private expenditure in total demand and

uc

Ė

ĻC ā” ā’ >0

ĖĀÆ

ucc C

Ė ĀÆ Ė ĀÆĀÆ

is the intertemporal elasticity of substitution; and gt = Gt + sC Ct , where Gt ā” (Gt ā’ G)/Y

indicates ļ¬‚uctuations in government purchases, measured in units of steady-state GDP, and

ucĪ¾

Ė

ĀÆ

Ct ā” ā’ ĀÆ Ī¾t

C ucc

Ė

14

Note that the appearance in (1.32) of the inļ¬‚ation rate rather than of the inļ¬‚ation rate relative to

steady-state inļ¬‚ation depends on our assumption that the steady-state inļ¬‚ation rate is zero.

24 CHAPTER 2. PRICE-LEVEL DETERMINATION

indicates the percentage change in private expenditure required to keep marginal utility

constant. (In fact, the notation āgt ā is used for the disturbance in (1.33) because variations

in government purchases are one of the most obvious reasons for the existence of shifts in

this factor.)

A corresponding log-linear approximation to the Wicksellian policy rule (1.30) is given

by

Ė

Ėt = Ļp Pt + Ī½t ,

Ä± (1.34)

Ė

where Pt ā” log(Pt /Ptā— ), and Ļp ā„ 0 represents the elasticity of Ļ with respect to P/P ā— ,

evaluated at the steady-state values of its arguments.15 To the system of log-linear equations

(1.32) and (1.34) we must also adjoin the identity

Ė Ė ā—

Ļt = Pt ā’ Ptā’1 + Ļt , (1.35)

where Ļt ā” log(Ptā— /Ptā’1 ) indicates the exogenous ļ¬‚uctuations, if any, in the target inļ¬‚ation

ā— ā—

rate. We then wish to examine the bounded solutions to the system of log-linear equations

(1.32), (1.34), and (1.35).

Using (1.34) and (1.35) to substitute for Ėt and Ļt+1 in the Fisher equation (1.32), we

Ä±

Ė

obtain an expectational diļ¬erence equation in the variable Pt alone, given by

Ė Ė ā—

(1 + Ļp )Pt = Et Pt+1 + (Ėt + Et Ļt+1 ā’ Ī½t ).

r (1.36)

Given a policy rule for which Ļp > 0, as called for by Wicksell, so that 0 < (1 + Ļp )ā’1 < 1,

this equation can be solved forward (as discussed further in the appendix), to obtain a unique

bounded solution

ā

Ė (1 + Ļp )ā’(j+1) Et [Ėt+j + Ļt+j+1 ā’ Ī½t+j ],

ā—

Pt = r (1.37)

j=0

rā—

in the case of any bounded exogenous processes {Ėt , Ļt , Ī½t }. Substitution of this solution

into (1.34) then yields an associated unique bounded solution for the nominal interest-rate

15

In writing the disturbance term simply as Ī½t , we adopt the normalization under which ā‚Ļ/ā‚Ī½ = 1 + ĀÆ =

Ä±

ā’1

Ī² , when also evaluated at the steady-state values of the arguments.

1. PRICE-LEVEL DETERMINATION IN A CASHLESS ECONOMY 25

dynamics as well, namely

ā

Ļp (1 + Ļp )ā’(j+1) Et [Ėt+j + Ļt+j+1 ā’ Ī½t+j ] + Ī½t ,

ā—

Ėt =

Ä± r (1.38)

j=0

while substitution into (1.35) yields a corresponding solution for the equilibrium rate of

inļ¬‚ation.

We thus obtain the main result of this section.16

Proposition 2.3. Under a Wicksellian policy rule (1.30) with Ļp > 0, the rational-

expectations equilibrium paths of prices and interest rates are (locally) determinate; that is,

there exist open sets P and I such that in the case of any tight enough bounds on the ļ¬‚uc-

rā—

tuations in the exogenous processes {Ėt , Ļt , Ī½t }, there exists a unique rational-expectations

equilibrium in which Pt /Ptā— ā P and it ā I at all times. Furthermore, equations (1.37) and

(1.38) give a log-linear (ļ¬rst-order Taylor series) approximation to that solution, accurate up

to a residual of order O(||Ī¾||2 ), where ||Ī¾|| indexes the bounds on the disturbance processes.

See further discussion in the appendix.

Thus there may be a well-deļ¬ned rational-expectations equilibrium path for the price

level, even in a purely cashless economy, and even under a policy rule that is formulated

in terms of an interest-rate rule ā” i.e., a rule for setting a short-term nominal interest

rate that is independent of the evolution of any monetary aggregate. It is true that the

regime described above assumes an exogenously given path for the monetary base Mts . But

it should not therefore be assumed that it is the existence of a āmoney growth targetā that

is responsible for the existence of a determinate price level; for the equilibrium price level

(1.37) is independent of the assumed path of the monetary base.

Indeed, in a cashless economy, a money growth target will not succeed in determining

16

Kerr and King (1996) provide an early discussion of the determinacy of equilibrium under a rule of this

kind, in a log-linear framework similar to the one derived here as an approximation to our exact equilibrium

conditions. Woodford (1998a) demonstrates determinacy of equilibrium under a Wicksellian regime in the

context of a complete intertemporal equilibrium model, along lines similar to those followed here, although

the means by which the central bank is assumed to implement its interest-rate operating target is diļ¬erent

there.

26 CHAPTER 2. PRICE-LEVEL DETERMINATION

an equilibrium price level ā” at least if such a policy is understood to involve a constant

(typically zero) rate of interest on the monetary base. In the case that no interest is paid on

money, the following result implies that no equilibrium price level is possible at all.

Proposition 2.4. Consider a monetary policy under which the monetary base is

bounded below by a positive quantity: Mts ā„ M > 0 at all times. (For example, per-

s

haps the monetary base is non-decreasing over time, starting from an initial level M0 > 0.)

Suppose furthermore that government debt is non-negative at all times, so that Dt ā„ Mts .

Finally, suppose that im = 0 at all times. Then in the cashless economy described above,

t

there exists no rational-expectations equilibrium path for the price level {Pt }.

The proof is in the appendix. Results of this kind are often taken (see, e.g., Sargent, 1987,

sec. 4.1) to imply that it is not possible to model the determinants of the exchange value of

money without introducing some kind of frictions that create a demand for money despite

its low rate of return. Hence monetary frictions are thought to be an essential element of

any theory of the eļ¬ects of monetary policy. But we have seen instead that an equilibrium in

which money exchanges for goods is possible even in a cashless economy, as long as the rate

of interest paid on money is high enough relative to the growth rate of the money supply.

Of course, in actual economies like that of the U.S., interest is not paid on the monetary

base, so that the policy regime in place would seem to be one to which Proposition 2.4

would apply, were the economy cashless. One might then conclude that monetary frictions

are essential to understanding inļ¬‚ation determination in an economy like that of the U.S.

But in fact, monetary frictions are essential only to understand one aspect of current U.S.

policy ā” the fact that it is possible for the Fed to implement its operating targets for the

federal funds rate without paying interest on Fed balances. As we shall see, the details of

how the Fed is able to implement its interest-rate targets are of relatively little importance

for the eļ¬ects of its interest-rate policy on price-level determination; and a cashless model

may give a good account of the latter question.

1. PRICE-LEVEL DETERMINATION IN A CASHLESS ECONOMY 27

Even when interest is paid on the monetary base at a suļ¬cient rate to allow a monetary

equilibrium to exist, if the interest rate on money is constant, the equilibrium price level

will be indeterminate, as a consequence of Proposition 2.5 in the next section, whether

or not the monetary base is kept on a precise deterministic growth path. Determinacy of

equilibrium requires a regime under which interest rates respond systematically ā” in the

right way, of course ā” to variations in the price level. In standard models with monetary

frictions, money-growth targeting (with a constant rate of interest on money) is an example

of a policy with this property: price-level increases automatically result in increases in short-

term nominal interest rates. But in a cashless economy, money-growth targeting has no such

consequence for interest rates, and so fails to determine an equilibrium price level. It is

actually the presence of a systematic relation between prices and interest rates, of the kind

called for Wicksell, that is essential for determinacy of equilibrium, and not control of the

money supply as such.

Proposition 2.3 does not simply establish conditions under which a monetary equilibrium

is possible: it gives a precise account of the factors that determine the equilibrium price level

under such a regime. Equation (1.37) may equivalently be written

ā

Ļ•j Et [log Pt+j + Ļā’1 (Ėt+j ā’ Ī½t+j )],

ā—

log Pt = pr (1.39)

j=0

where the weights Ļ•j ā” Ļp (1+Ļp )ā’(j+1) are all positive and sum to one. Thus the equilibrium

log price level is equal (up to terms of order O(||Ī¾||2 )) to a weighted average of the current

and expected future log price level targets, plus a deviation term that is itself a weighted

average of current and expected future disturbances to the equilibrium real rate of interest

and disturbances to the monetary policy rule other than those represented by variations in

the ātargetā price level.17 The determinants of variations in the equilibrium real interest rate

17

Note that insofar as we regard the target price level as being implicit in the central bankā™s reaction

function, rather than an explicit target, the distinction between variations in the target price level and

variations in Ī½t is an arbitrary one; and as we should expect, (1.39) indicates that only the sum log Ptā— ā’

(Ļā’1 + 1)Ī½t actually matters, in our log-linear approximation, for determination of the equilibrium price

p

level. But for some purposes, it remains useful to distinguish the two components; for example, we allow

log Ptā— to possess a trend, but assume that Ī½t is stationary.

28 CHAPTER 2. PRICE-LEVEL DETERMINATION

are in turn given by (1.33); these depend solely upon exogenous real factors, independent

of monetary policy. Note that the associated evolution of the monetary base {Mts } is not

among the relevant factors.

The theory of price-level determination under such a regime that we obtain has, in fact, a

distinctly Wicksellian ļ¬‚avor. Equation (1.39) indicates that increases in the equilibrium price

level result either from exogenous increases in the equilibrium real rate of return (Wicksellā™s

ānaturalā rate of interest),18 that are not suļ¬ciently oļ¬set by an adjustment of the central

bankā™s operating target, or from a loosening of monetary policy (corresponding either to

an increase in Ptā— or a decrease in Ī½t ), that is not justiļ¬ed by any real disturbance. This

emphasis upon the interplay between variations in the equilibrium real rate and the stance of

monetary policy (and speciļ¬cally upon the gap between the current level of the ānatural rateā

of interest and the interest rate controlled by the central bank) as the source of inļ¬‚ationary

or deļ¬‚ationary pressures recalls Wicksellā™s theory (Wicksell, 1898, 1915).

Of course, our rational-expectations equilibrium version of Wicksellian theory diļ¬ers in

important ways from the original. For example, our solution (1.39) for the equilibrium

price level is forward-looking, in much the same way as the rational-expectations monetarist

analysis presented in section xx below. It is not simply the current equilibrium real rate of

return that matters, but a weighted average of current and expected future rates, and it is

not simply the current stance of monetary policy that matters, but a weighted average of

the current and expected future shifts in the central bankā™s feedback rule. Perhaps more

crucially, our theory does not determine an equilibrium price level as a function of the

path (even including expectations about the future path) of the central bankā™s interest-rate

instrument. Rather, the price level depends upon the current and expected future feedback

rules for determination of the interest rate as a function of the evolution of the price level.

(For an exogenously speciļ¬ed interest-rate process leaves the price level indeterminate, as

shown above.)

18

In the simple analysis here, there is no distinction between the actual and ānaturalā real rates of interest.

This is introduced in chapter 4, where we ļ¬nd that it continues to be possible to understand price-level

determination along similar lines.

2. ALTERNATIVE INTEREST-RATE RULES 29

Nonetheless, the implications of this theory for the conduct of monetary policy with a

view to price stability are reminiscent of Wicksellā™s prescriptions. First of all, supposing that

the target price level Ptā— is constant,19 and letting Ļp > 0 be ļ¬xed, then monetary policy

achieves the constant price level Pt = P ā— if and only if Ī½t = rt at all times. Failure of policy

Ė

to track such variations in the ānatural rateā with suļ¬cient accuracy was, in Wicksellā™s

account, the primary explanation for price-level instability.20

Second, our results imply that for any given degree that the shift factor Ī½t fails to track

the exogenous variation in rt , the price-level instability that results can be reduced by a

Ė

sharper automatic positive response of the central bankā™s operating target to price-level

increases. The eļ¬ects upon log Pt of variations in the gap rt ā’ Ī½t are smaller the larger is Ļp ,

Ė

and in fact they can be made arbitrarily small, in principle, by choosing Ļp large enough.21

Thus, a positive automatic response to price-level deviations from target is desirable, not

only because it is necessary for determinacy (this would be achieved by even a very small

Ļp > 0), but because it reduces the degree to which accurate direct observation of the current

equilibrium real rate is necessary in order for price-level variability to be kept at a given level.

This too is a theme in Wicksellā™s discussions of desirable policy.

2 Alternative Interest-Rate Rules

While most central banks organize their monetary-policy deliberations around the choice of

an operating target for a short-term nominal interest rate, and pay a great deal of attention

19

Similar conclusions are reached in the case of a target price level that grows at a constant rate; one must

simply add a constant to the value of Ī½t required each period to achieve the target.

20

See, e.g., Wicksell (1915, sec. IV.9). He found evidence for this in the often-remarked tendency of the

price level to covary positively with the level of nominal interest rates during the period of the classical gold

standard (the so-called āGibson paradoxā). Note that if Ī½t = 0, (1.39) implies that log Pt should vary with

exogenous variations in the real rate, while (1.34) then implies that the endogenous variations in the short

nominal rate should perfectly coincide with these ļ¬‚uctuations in the price level. A similar conclusion is

obtained if Ī½t covaries positively, but less than one-for-one, with the variations in rt , so that the inļ¬‚ationary

and deļ¬‚ationary impulses are not completely eliminated.

21

It is unlikely to be desirable, however, to seek to completely eliminate price-level variation without any

need to directly respond to variations in the equilibrium real rate, by choosing a rule with an extremely large

elasticity Ļp . For in this case, errors in the measurement of the price level by the central bank would have

very large eļ¬ects upon policy, and hence upon the economy, as discussed in Bernanke and Woodford (1997).

30 CHAPTER 2. PRICE-LEVEL DETERMINATION

to inļ¬‚ation measures in those deliberations, it would be hard to argue that the Wicksellian

rule (1.30) represents even a rough description of the current behavior of any central banks.

(In particular, central banks clearly accept ābase driftā in the price level, rather than seeking

to stabilize a price index around an exogenously given target path.) Nor shall we argue that

this is actually an optimal rule, though such a rule can be shown to have desirable properties,

relative to other rules of equal simplicity (Giannoni, 2000). It is therefore useful to extend

our analysis to other types of interest-rate rules. While a complete treatment of the topic

would be beyond the scope of this study, we here take up a few additional cases suggested

by the discussion of empirical central-bank reaction functions in chapter 1.

2.1 Exogenous Interest-Rate Targets

The simplest sort of interest-rate rule, of course, would be one that involves no feedback from

any endogenous variables. We might instead suppose that the central bankā™s interest-rate

operating target is given by some exogenous stochastic process {ĀÆt }. This need not imply that

Ä±

the sole objective of policy is interest-rate stabilization (or maintenance of āeasy moneyā). A

central bank concerned with price stability, and believing in the theoretical model of section

1, might reason that a rational-expectations equilibrium with constant prices is possible only

if

ā’1

uc (Yt+1 ; Ī¾t+1 )

ā’1

1 + it = 1 + rt ā” Ī² Et , (2.40)

uc (Yt ; Ī¾t )

as a consequence of (1.21). Supposing that it is possible for the central bank to measure the

exogenous variation in the right-hand side of this equation in time to use this information in

the conduct of policy, would the bank achieve its objective by committing itself to a policy

of always adopting the current value of rt as its operating target? (Such a proposal might

appear to be suggested by a Wicksellian analysis of the determinants of inļ¬‚ation, although,

as noted in chapter 1 and in the previous section, this is the not the kind of rule actually

proposed by Wicksell.)

While such a policy would be consistent with the desired rational-expectations equi-

librium, it would also be equally consistent with an extremely large class of alternative

2. ALTERNATIVE INTEREST-RATE RULES 31

rational-expectations equilibria, in most of which prices vary randomly. This is true even if,

as above, we restrict attention to alternative equilibria that remain forever near the reference

equilibrium, i.e., the steady state with zero inļ¬‚ation. In fact, this is a consequence of any

policy commitment that makes the interest-rate operating target purely a function of the

economyā™s exogenous state (i.e., the history of disturbances alone), regardless of how sensibly

the exogenous sequence of interest-rate targets may have been chosen.

Proposition 2.5. Let monetary policy be speciļ¬ed by an exogenous sequence of

interest-rate targets, assumed to remain forever within a neighborhood of the interest rate

ĀÆ > 0 associated with the zero-inļ¬‚ation steady state; and let these be implemented by setting

Ä±

im equal to the interest-rate target each period. Let {Mts , Dt } be exogenous sequences of

t

the kind assumed in Proposition 2.3. Finally, let P be any neighborhoods of the real num-

ber zero. Then for any tight enough bounds on the exogenous processes {Yt , Ī¾t Dt /Dtā’1 }

and on the interest-rate target process, there exists an uncountably inļ¬nite set of rational-

expectations equilibrium paths for the price level, in each of which the inļ¬‚ation rate satisļ¬es

Ļt ā P for all t. These include equilibria in which the inļ¬‚ation rate is aļ¬ected to an arbitrary

extent by āfundamentalā disturbances (unexpected changes in Yt or Ī¾t ), by pure āsunspotā

states (exogenous randomness unrelated to the āfundamentalā variables), or both.

In this case, any process {Pt } that satisļ¬es both (1.21) and (1.24), given the exogenous

processes {Yt , Ī¾t , im , Mts , Dt }, and with the exogenous target im substituted for it in (1.21),

t t

represents a rational-expectations equilibrium. For any tight enough bounds on the exoge-

nous processes and on the neighborhood P, (1.24) is necessarily satisļ¬ed, so our question

reduces to an analysis of the local uniqueness of solutions to (1.21) for a given interest-rate

process. As in the previous section, this can be addressed through a consideration of the

uniqueness of bounded solutions to the log-linearized equilibrium condition (1.32). This now

takes the form

ĀÆt = rt + Et Ļt+1 ,

Ä± Ė (2.41)

32 CHAPTER 2. PRICE-LEVEL DETERMINATION

where ĀÆt indicates the exogenous ļ¬‚uctuations in the interest-rate target and rt the exogenous

Ä± Ė

ļ¬‚uctuations in rt owing to random āfundamentalsā, again given by 1.33). This equation

obviously has a unique solution for Et Ļt+1 , and if the exogenous terms are bounded, the

implied ļ¬‚uctuations in the expected inļ¬‚ation rate will be bounded as well. But this equation

does not have a unique bounded solution for the stochastic process {Ļt }, for absolutely any

pattern of bounded ļ¬‚uctuations in the unexpected component of the inļ¬‚ation rate will be

consistent with it.

Writing this explicitly, we observe that

Ļt = ĀÆtā’1 ā’ rtā’1 + Ī½t

Ä± Ė (2.42)

is a bounded solution to (2.41), where {Ī½t } represents any mean-zero bounded process that

is completely unforecastable a period in advance, i.e., that satisļ¬es

Et Ī½t+1 = 0

at all dates. It then follows from the discussion in section xx of the appendix that we similarly

have an uncountably inļ¬nite set of bounded solutions to the exact equilibrium condition.

(1.21).2223

Here the random variable Ī½t may be correlated in an arbitrary way with unforecastable

Ä±Ė

variations in āfundamentalā variables such as ĀÆt , Yt , and Ī¾t ; but it may also be completely un-

related to economic fundamentals. Thus even when we restrict attention to nearby solutions,

the rational expectations equilibrium price level is quite indeterminate under such a regime.

Note furthermore that even though we consider only alternative solutions in which inļ¬‚a-

tion is always within a certain neighborhood of zero, this set of solutions includes alternative

22

There is actually no need for linearization to establish this, as shown in the appendix. Here we use the

method of linear approximation in the analysis of determinacy to illustrate the method, that is used again

later in more complicated cases.

23

It is important to note that this conclusion depends on a particular assumption about the character of

ļ¬scal policy. If ļ¬scal policy were not assumed, as it has been here, to be ālocally Ricardian,ā then there

might be a locally, or even globally unique equilibrium in the case of an exogenous path for the interest-rate

operating target. This occurs, for example, in the analysis of price-level determination under a bond-price

support regime in Woodford (2001xx). See further discussion in section xx of chapter 4.

2. ALTERNATIVE INTEREST-RATE RULES 33

paths for the price level that wander arbitrarily far from one another, once suļ¬cient time has

passed. This is the basis for the conclusion of Sargent and Wallace (1975) that interest-rate

rules are ļ¬‚awed as a general approach to monetary policy, and that policy should instead be

formulated in terms of monetary targets.24

One might ask, is this sort of price-level indeterminacy really a problem? It will be

observed in our discussion here that real quantities are unaļ¬ected by the indeterminacy of

the price level, and the same conclusion is true even in the case of the model with monetary

frictions considered below in section xx, and even in a more elaborate model, in which

output is endogenous and may depend upon the level of real money balances. Thus no

variables that actually aļ¬ect household utility are aļ¬ected. However, the indeterminacy is

plainly undesirable if price stability is a concern, as Sargent and Wallace assume in their

analysis of optimal monetary policy. Indeed, since the class of bounded solutions includes

solutions in which the unexpected ļ¬‚uctuations in inļ¬‚ation are arbitrarily large, at least

some of the equilibria consistent with the interest-rate targeting policy are worse (assuming

a loss function that penalizes squared deviations of inļ¬‚ation from target, say) than the

equilibrium associated with any policy that makes equilibrium determinate. Furthermore,

similar conclusions are shown below (in chapter 4) to hold in the case of a model with

nominal price rigidity, in which case the self-fulļ¬lling expectations also aļ¬ect real variables,

that matter for household utility. Thus, if one evaluates policy rules according to how bad

is the worst outcome that they might allow, it would be appropriate to assign an absolute

priority to the selection of a rule that would guarantee determinacy of equilibrium.

This argument might seem inconsistent with our use above of a purely local analysis of

determinacy. One response to such a concern would be to refer to the exact analysis in

section xx of the appendix, and show that there are indeed solutions involving arbitrarily

large unexpected changes in the log price level. But in fact the local analysis is also valid,

when correctly interpreted. Let us ļ¬x neighborhoods of the steady-state values of Ļt , it ,

24

See Walsh (1998, sec. 10.2.1) for an exposition of their analysis in the context of an IS-LM model with

rational expectations that is closer to the structure of the model actually used in the original paper.

34 CHAPTER 2. PRICE-LEVEL DETERMINATION

and so on, that are small enough that the approximation error in the log-linearized relation

(1.32) is of an acceptable size, for all paths remaining within these neighborhoods; we shall

restrict attention to solutions of this kind. The analysis of the log-linearized equations

shows that in the case of the exogenous interest-rate target, there exist solutions in which

the inļ¬‚ation rate ļ¬‚uctuates over the entire admissible neighborhood, no matter how small the

ļ¬‚uctuations in the exogenous disturbances may be. Now let us compare such a policy to one

that results in a determinate equilibrium (and hence a solution in which Ļt and the other

endogenous variables are linear functions of the exogenous disturbances, with coeļ¬cients

that are independent of the assumed shock variances). We observe that by making the

exogenous disturbances small enough, we obtain a case in which the inļ¬‚ation variability

in at least certain equilibria associated with interest-rate targeting is much greater than in

the locally unique equilibrium associated with the other policy. Thus, at least in the case

of small enough exogenous disturbances, the conclusion reached from the analysis of the

log-linearized equations is correct.

Whether one should only care about the worst possible equilibrium might be doubted, if

a particular policy also allows very desirable equilibria, that are better than those associated

with any other policies. But in fact, this is unlikely to be a serious problem, once the class

of policies that are considered is suļ¬ciently broad; for it is often possible to achieve any

desired equilibrium through a policy rule that makes equilibrium determinate, in addition

to its being consistent with rules that would make equilibrium indeterminate. There are

typically many policy rules consistent with the desired equilibrium; these coincide in what

they prescribe should occur in the desired equilibrium, but diļ¬er in how policy is speciļ¬ed

āoļ¬ the equilibrium pathā, and thus may diļ¬er as to whether they exclude other nearby

equilibria. In such a case, it seems reasonable to accept as a principle of policy design

that one should choose one of the rules that makes the desired equilibrium at least locally

determinate, if not globally unique. We shall take this perspective in the current study; see

chapter 8.

Fortunately, interest-rate rules as such need not imply indeterminacy of equilibrium, as

2. ALTERNATIVE INTEREST-RATE RULES 35

McCallum (1981) ļ¬rst noted, in the context of the model of Sargent and Wallace. A rule

that involves a commitment to feedback from endogenous state variables such as the price

level to the level of nominal interest rates can result in a determinate equilibrium, as our

analysis of Wicksellian rules in section 1 has shown. We now turn to additional examples

that are better descriptions of current policies.

ńņš. 1 |