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Tödter, Karl-Heinz

Working Paper

Monetary indicators and policy rules in the P-star

model

Deutsche Bundesbank

Suggested Citation: Tödter, Karl-Heinz (2002) : Monetary indicators and policy rules in the P-

star model, Discussion Paper Series 1, No. 2002,18, Deutsche Bundesbank, Frankfurt a. M.

http://hdl.handle.net/10419/19575

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Monetary indicators

and policy rules

in the P-star model

Karl-Heinz Tdter

Economic Research Centre

of the Deutsche Bundesbank

June 2002

the authors’ personal opinions and do not necessarily reflect the views

of the Deutsche Bundesbank.

Deutsche Bundesbank, Wilhelm-Epstein-Strasse 14, 60431 Frankfurt am Main,

Postfach 10 06 02, 60006 Frankfurt am Main

Telex within Germany 4 1 227, telex from abroad 4 14 431, fax +49 69 5 60 10 71

Press and Public Relations Division, at the above address or via fax No. +49 69 95 66-30 77

ISBN 3–935821–21–2

Abstract

There is a broad consensus among economists that, in the long run, inflation is a monetary

phenomenon. However, monetary policy is often analysed using models that have no

causal role for monetary aggregates in the propagation of inflationary processes. Moreover,

impulses from monetary policy actions are transmitted to inflation through the output gap

alone. This paper analyses monetary indicators and monetary policy rules within the

framework of a small monetary model, the P-star model. In this model monetary aggregates

play an active role in the transmission mechanism of monetary policy actions. Interest rate

impulses affect inflation through two channels, the output gap and the liquidity gap.

Section 2 of the paper analyses monetary indicators of inflation. Using a long-run money

demand function, three monetary indicators are discussed: the monetary overhang, the price

gap, and the nominal money gap. The price gap is a comprehensive indicator of

inflationary pressure, combining information from the aggregate goods market (output gap)

and the money market (liquidity gap). Some implications of using the price gap in Phillips-

type equations for the dynamics of inflation are discussed as well.

Section 3 analyses the role of the price gap in the monetary transmission process more

closely. The P-Star model and a New-Keynesian-Taylor-type model are compared with

respect to their stability properties, implied sacrifice ratios and the efficiency of interest

rate policy in stabilising inflation and output fluctuations.

Section 4 explores a range of monetary policy rules within the P-star model. First, direct

inflation targeting, inflation forecast targeting, and optimal inflation targeting are analysed

and contrasted with a strategy of price-level targeting, often suggested as an alternative to

inflation-based rules. Second, assuming a more general loss function for the central bank, a

Taylor rule (focussing on inflation and output), monetary targeting and a two-pillar

strategy (focussing on monetary growth and inflation) are analysed. The performance of

these rules is investigated under perfect foresight and rational expectations of the central

bank. Moreover, these strategies are compared to two benchmarks, a passive rule and a

broadly based meta-strategy. Finally, monetary targeting as an intermediate targeting

strategy is compared to a Taylor rule when the central bank has an information advantage

with respect to monetary growth.

Zusammenfassung

Unter Ökonomen besteht ein breiter Konsensus dahingehend, dass Inflation auf lange Sicht

ein monetäres Phänomen ist. Gleichwohl wird die Geldpolitik häufig im Rahmen von

kleinen Modellen analysiert, in denen die Geldmenge in keinem kausalen Zusammenhang

zur langfristigen Entwicklung des Preisniveaus steht. Die Transmission geldpolitischer

Impulse erfolgt nur über den Auslastungsgrad. In diesem Papier werden monetäre

Indikatoren und geldpolitische Regeln im Rahmen eines kleinen monetären Modells

analysiert, des P-Stern – Modells. In diesem Modell spielen monetäre Aggregate eine

aktive Rolle im Transmissionsprozess geldpolitischer Impulse. Die Zinspolitik der

Notenbank beeinflusst die Inflationsentwicklung über zwei Kanäle, den Auslastungsgrad

und den Liquiditätsgrad.

Ausgehend von einer langfristigen Geldnachfragefunktion werden der Geldüberhang, die

Preislücke und die nominale Geldlücke verglichen. Die Preislücke ist ein umfassender

Inflationsindikator, der den vom Gütermarkt (Auslastungsgrad) und vom Geldmarkt

(Liquiditätsgrad) ausgehenden Inflationsdruck zusammenfasst. Ferner werden die

Implikationen der Preislücke in Phillips-Beziehungen für die Inflationsdynamik diskutiert.

Der Abschnitt 3 befasst sich eingehender mit der Rolle der Preislücke im monetären

Transmissionsprozess. Das monetäre P-Stern – Modell and ein Neu-Keynesianisches

Modell des Taylor – Typs werden im Hinblick auf ihre Stabilitätseigenschaften, die

stabilitätspolitische Effizienz der Zinspolitik sowie die Kosten einer Disinflationspolitik

verglichen.

Der Abschnitt 4 untersucht eine Reihe geldpolitischer Regeln im P-Stern – Modell. Die

direkte Inflationsteuerung, die Inflationsprognosesteuerung sowie die optimale

Inflationssteuerung werden untersucht und mit einer Strategie der Preisniveausteuerung

verglichen. Ausgehend von einer allgemeineren Zielfunktion für die Notenbank werden

ferner eine Taylor – Regel (Steuerung von Inflation und Output), die Geldmengen-

steuerung sowie eine Zwei-Säulen-Strategie (Steuerung von Geldmengenwachstum und

Inflation) untersucht. Das Abschneiden dieser Regeln wird für den Fall perfekter

Voraussicht sowie rationaler Erwartungen seitens der Notenbank analysiert. Außerdem

werden diese Strategien mit zwei Benchmark – Strategien verglichen, einer passiven Regel

sowie einer breit angelegten Meta-Strategie. Abschließend wird die Geldmengensteuerung

als Zwischenzielstrategie mit einer Taylor-Regel verglichen, wenn die Notenbank einen

Informationsvorsprung bezüglich des Geldmengenwachstums besitzt.

Contents

1. Introduction 1

2. Monetary indicators of price developments 2

2.1 Money demand 2

2.2. Monetary overhang 3

2.3 Price gap 3

2.4 Nominal money gap 4

2.5 Price dynamics 6

3.1 Taylor model 9

3.2 P-star modal 11

3.3 Empirical evidence 15

4.1 Inflation targeting 18

4.2 Price-level targeting 21

4.3 Taylor rule, monetary targeting and two-pillar strategy 23

4.4 Monetary targeting as an intermediate target strategy 27

Annex A: The price gap as part of an indicator system for monetary policy 30

References 35

List of tables and charts

Table 3.1 Relative efficiency of monetary policy 13

Table 3.2 Sacrifice ratio 15

Table 4.1 Performance of inflation targeting 21

Table 4.2 Inflation targeting versus price-level targeting 23

Table 4.3 Reaction coefficients of optimum strategies 25

Table 4.4 Variance with alternative strategies 26

Table 4.5 Performance of alternative strategies 26

Table 4.6 Monetary targeting as an intermediate target strategy 28

Table A2 Disequilibrium concepts 32

Monetary indicators and policy

rules in the P-star model*

1. Introduction

"These days, few economists would disagree with the statement that inflation is a monetary

phenomenon in the long run. Indeed, this statement is one of the central tenets of economic

theory. The long-run relationship between money and prices has been confirmed by an

impressive number of empirical studies, both across countries and across time."1 Even so,

analyses of monetary policy are often based on a Neo-Keynesian Taylor-type model, in

which money plays no part in the propagation of inflationary processes and monetary

policy impulses spread solely via the real demand for goods. This is not satisfactory from a

theoretical point of view, nor does it reflect the empirical evidence for the euro area. In the

P-star model, the money stock plays a causal role in the transmission process of monetary

impulses and monetary policy has an impact on economic development both through the

real demand for goods and via the demand for money.

This paper investigates monetary indicators and monetary policy rules on the basis of the

P-Star model. Starting with a long-term money demand function, chapter 2 discusses

alternative monetary indicators for price developments: the monetary overhang, the price

gap and the nominal money gap. Chapter 3 investigates the role of the price gap in the

monetary transmission process, the relative efficiency of inflation and output stabilisation

in the Taylor and the P-star models, and the costs of a disinflationary policy. Chapter 4

discusses the behaviour of various monetary policy rules (inflation targeting, price-level

targeting, the Taylor rule, monetary targeting and a two-pillar strategy) in the context of the

P-star model. Chapter 5 contains a summary with conclusions.

* The opinions expressed in this paper do not necessarily reflect the views of the Deutsche Bundesbank. I

wish to thank my colleagues at the Research Centre, the participants in a Friday seminar and, in particular,

Hans-Eggert Reimers and Franz Seitz for their extremely helpful comments. Any remaining errors and

shortcomings are, of course, my own.

1 Issing (2001, p 5). On the ECB's monetary policy strategy, see European Central Bank (1999, 2000) and

on the Bundesbank's monetary policy strategy, see Issing (1994) and König (1996).

–1–

2. Monetary indicators of price developments

usefulness of measurements in policymaking. The conceptual

framework that defines and constrains what is measured and

how it is measured establishes the effectiveness and usefulness of

those measurements.” (Humphrey 2001)

The production function and the money demand function are important components of

macroeconomic models. The production function characterises the production process and

the money demand function characterises the transaction process of an economy. A

production function is often used for determining potential output and the degree of

capacity utilisation. In this paper, a money demand function is used to complement

potential output by a monetary equilibrium variable – the equilibrium price level. The price

gap, i.e. the difference between the equilibrium price level and the current price level is an

indicator of inflationary pressure reflecting both the real economic factors (output gap) and

monetary effects (liquidity gap).2 This indicator combines – roughly speaking – the excess

demand for goods (realised demand) and the excess supply of money (potential demand).

2.1 Money demand: The cornerstone of the following analysis of monetary indicators

of price developments is the assumption that a stable long-term money demand function

exists which is homogenous in terms of prices:3

(2.1) md = p + ß y − γ i

To simplify the notation, the time index (t) for variables is mostly omitted, as is the explicit

statement of level constants. With the exception of i, lower-case letters designate the

natural logarithms of the variables having the matching upper-case letters. Md is the money

demand, P the price level and Y real output. The opportunity costs of cash holdings (i) may

be a long-term interest rate or - in the case of broad monetary aggregates - an interest-rate

differential. The signs are stated explicitly; the coefficients themselves are therefore to be

regarded as absolute values: ß is the income elasticity and γ is the semi-interest-rate

elasticity of money demand.

2 For the measurement of surplus liquidity, see also Köhler and Stracca (2001).

3 For the derivation of money demand functions from a microeconomic optimisation approach, see

Woodford (1996). Lucas (1996) discusses price homogeneity and long-term neutrality of money. Sriram

(2001) gives an overview of recent empirical studies, Serletis (2001) analyses micro-based (Divisa)

aggregates.

–2–

2.2 Monetary overhang: Owing to information and adjustment costs, the money stock

(M) available at any given time may differ from the demand for money. The relative

difference between the money stock and money demand is described as monetary overhang

(u):

(2.2) m = md + u

the differences between the existing money holdings and the demand for money holdings

resulting from the current economic situation (measured by y and i). If the money demand

function forms a stable cointegration relationship, the monetary overhang is a stationary

variable (error correction term) which contains information on the future development of

the money stock. Dynamic processes of adjustment ensure that, following a disturbance,

the money holdings adjust to the path defined by the money demand (Engle and Granger

1987).

2.3 Price gap: The equilibrium money stock (M*) is defined as the money stock

demanded given the prevailing general price level if both the goods and the money markets

were in equilibrium:

(2.3) m* = p + ß y * − γ i *

where Y* is potential output and i* the equilibrium interest rate.4 The relative difference

between the current money stock and the equilibrium money stock is described as the

money gap:5

Instead of measuring these disequilibria in units of the (logarithmic) money stock, they can

also be expressed in an equivalent manner in units of the (logarithmic) price level. To do

this, the equilibrium price level (P-star) is defined as the price level that would emerge

given the current holdings of money if both the goods market and the money market were

in equilibrium:

4 On the estimation of potential output, see McMorrow and Roeger (2001), Alvarez et al (2000) as well as

Tödter and von Thadden (2000).

5 Svensson (2000) refers to the money gap as the real money gap: m – m* = (m-p) – (m* – p). The value

of this extension is doubtful, however, as any other variable could be inserted instead of p.

–3–

(2.5) p* = m − β y * + γ i *

The equilibrium price level is thus an indicator of the level of goods prices that would

emerge over the longer term given the existing money stock if the disequilibria (y - y*,

i - i*, u) had disappeared. As may easily be seen, the price gap and the money gap are

identical:

This reflects the fact that inflation, in the long term, is a monetary phenomenon. Upward

price pressure may result from the combination of three factors: the utilisation of

production capacity is high (capacity pressure), the interest-rate level is lower than in

equilibrium (interest-rate pressure) or a monetary overhang exists (money supply pressure).

Hallman et al (1989, 1991) originally derived the price gap from the quantity equation

( p + y = m + v ) and defined the equilibrium velocity of circulation of money as

v* = p * + y * − m . This results in a breakdown of the price gap into the output gap and the

liquidity gap:

(2.7) p * − p = ( y − y*) + ( v * − v)

The liquidity gap indicates inflationary pressure if the velocity of circulation of money is

smaller – i.e. cash holdings are higher – than in equilibrium. In conjunction with (2.1), it

may be demonstrated that the liquidity gap consists of three components:

The first component is a spill-over effect from the goods market which emerges if the

income elasticity of the money demand deviates from one. The two other components are

interest-rate pressure and money supply pressure.6

2.4 Nominal money gap: The nominal money gap is an indicator of the (cumulative)

deviations of the money stock from the monetary target. Assume that the central bank sets

itself the inflation target π̂ t for each period. Starting from a base period (t = 0), the implied

6 Some authors determine the equilibrium price level using a time series approach from the trend of output

and the velocity of circulation of money, with Groeneveld (1998) applying a Kalman filter, whereas

Scheide and Trabandt (2000) use the Hodrick-Prescott filter.

–4–

price level target is defined as the accumulation of the inflation targets: p̂ = p o + å πˆ τ .

On account of (2.1), a target level for the money stock consistent with this is:

(2.9) m̂ = p̂ + βy * − γ i *

The nominal money gap is the relative difference between the current money stock and the

central bank's implicit monetary target. This indicator thus measures the cumulative

deviations from the monetary target. As may be seen from

the nominal money gap is made up of the "price target gap" and the price gap. The nominal

money gap is not a suitable indicator of future inflation potential, since it contains price

rises that have already been realised.

In terms of their informative value for the development of inflation, there is a systematic

relationship between the monetary indicators. The monetary overhang measures inflation

potential resulting from a disquilibrium on the money market. The price gap (money gap)

captures the inflation potential resulting from disequlibria on the money and goods

markets. The nominal money gap is a performance indicator of monetary targeting.

Realised

Future inflation potential (p* - p) Excessive

Inflation

Liquidity pressure (v* - v) Capacity

pressure

Money supply Spill-over Interest-rate

pressure pressure (y – y*) ( p − p̂)

u (ß-1)(y-y*) - γ (i - i*)

Monetary overhang

Price gap

(or money gap)

Nominal money gap

The P-star approach links disequilibria on the goods and money markets to form a

consistent and comprehensive indicator of inflationary pressure. The price gap is thus a

potentially important variable for explaining and forecasting inflation. The price gap may

also be useful, however, as part of a broader system of indicators for analysing economic

developments in other areas. Annex A demonstrates how the price gap can be used for

–5–

constructing an indicator for the labour market and the foreign exchange market.

Furthermore, it is shown how the balance of the government sector can be broken down

into a structural and a cyclical component using the output gap and the price gap.

2.5 Price dynamics: If the price gap is a useful indicator of potential inflation, it should

play a part in helping to explain inflation dynamics and, in the long run, determine the

development of the general price level. This contrasts with microeconomic approaches in

which the optimum price level of an enterprise (indexed by i) producing under

monopolistic competition is proportionate to the marginal costs of production

~ ∂C(Yi )

(2.11) Pi = µ

∂Yi

where µ (≥ 1) is a mark-up factor which depends on the price elasticity of demand. Under

certain assumptions, such cost-pressure approaches may be used to derive an aggregated

Phillips relationship for the inflation rate as a function of inflation expectations, the degree

of capacity utilisation and the supply shock:7

(2.12) ∆p = ∆p e + λ ( y − y*) + υ

These approaches may explain the relative prices, but not persistent changes in the general

price level. Cost increases or supply shocks, which affect all firms equally, can be passed

on to the product prices on a lasting basis only under certain underlying macroeconomic

conditions. If all enterprises want to change their prices, it is possible that none of them

ultimately succeeds in doing so, as Humphrey (1998, p 54) states, "Here then is the cost-

push fallacy: it confounds relative with absolute prices and sectoral real shocks with

economywide nominal ones. It says nothing about money's role in price determination."

Inflation in these approaches is a non-monetary phenomenon.

enterprises set their prices not only with an eye to the corporate optimum (2.11). They also

take due account of the opportunity costs that arise if price formation does not pay attention

to the underlying macroeconomic conditions set by monetary policy. In the approach by

Rotemberg (1982), the firms weigh up the costs of price changes against the costs caused

by deviations from their equilibrium price. If the deviations from both the corporate

7 See Gali and Gertler (1999), Gali et al (2001) as well as Mehra (2000). Roberts (1998) explains the

relationship between alternative Neo-Keynesian approaches.

–6–

~

equilibrium (Pi ) and from the macroeconomic equilibrium (P*) are taken into account, the

following optimisation approach is obtained

[ ]

∞

(2.13) Min K it = E t å θ τ − t κ(p i τ − ~

pi τ ) 2 + η(p i τ − p*τ ) 2 + (p i τ − p i τ −1 ) 2

p it τ= t

pi is the corporate equilibrium

price and p* is the macroeconomic equilibrium price level – all in logs. θ is a constant

discounting factor, κ and η are parameters which measure the amount of the disequilibrium

costs in relation to the costs of price changes. The first-order condition gives the following

expression:

(2.14) {

E t κ( p i t − ~ }

pi t ) + η(p i t − p*t ) + (pi t − pi t −1 ) − θ(p i t +1 − pi t ) = 0

pi t − pi t ) + η(p*t − pi t )

Fluctuations in the marginal production costs are often approximated by changes in the

output gap. If ~

pi t is substituted by pi t + γ ( yit − y t ) + υ / κ , where yi t − y t designates the

deviations from the average level of output and υ a non-firm-specific shock term (Roberts

1995). If the discounting factor is set approximately at one, the expectation operator is

replaced by a higher-case e and the time index is omitted, (2.15) may be written more

compactly as

where λ = κ γ. The inflation rate of enterprise i depends on the expected inflation rate, the

relative demand situation which the enterprise faces, on the difference vis-à-vis the

equilibrium price level and on price shocks which affect all enterprises. The future inflation

rate appears in (2.16) owing to price rigidities. If the demand faced by the enterprise i is

designated as yi = y + εi , it follows from (2.16) for the relative price changes

Hence, the relative price changes depend on the relative inflation expectations and the

relative demand shocks. Differences in the relative prices are temporary. Factors affecting

all enterprises in the same way do not have an impact on the relative prices. By contrast,

–7–

the aggregate inflation rate is solely a function of macroeconomic determinants, inflation

expectations and the price gap:

(2.18) ∆p = ∆p e + η (p * − p) + υ

In this setting, price adjustment processes take place until an equilibrium is achieved on the

goods and money markets. The money stock has an influence on the emergence and

propagation of inflationary processes. The price gap ensures that the uncoordinated sales

plans of the enterprises adjust in the longer term to demand in the economy as a whole.

This has important implications for the transmission of monetary policy impulses. In

traditional Phillips relationships, monetary impulses have an impact on the inflationary

process only through the real demand for goods. In the extended Phillips relationship

(2.18), monetary impulses can also have an effect on price developments by means of their

liquidity effects. Cost or productivity shocks, which affect all enterprises, have a lasting

impact on the general price level only if they are accommodated monetarily. Conversely, an

abundant provision of liquidity may have inflationary effects before it is reflected in real

demand. With regard to the P-star approach, Baltensperger (2000, p 105) points out that a

price-adjustment equation of this kind does not have a macroeconomic foundation which is

beyond all doubt, although this applies equally to alternative price-adjustment equations

and, in particular, to the Phillips curve formula preferred by Svensson and the standard

macroeconomic approach.

Under discussion in recent times have been approaches which explain price developments

not in terms of costs or demand, but – by analogy with the valuation of assets – by the ratio

of government debt to the expected discounted value of future budgetary surpluses.

Annex B will briefly go into the fiscal theory of the price level.

–8–

3. The price gap in the monetary transmission process

standard practice – for monetary policy analysis to be

conducted in models that include no reference to any

monetary aggregate." (McCallum (2001)

Monetary policy is increasingly being studied using small macroeconomic models in which

monetary aggregates do not play an active role.8 This applies, for example, to the models

used by Svensson (1997, 1998, 1999a), Blinder (1998) and Bernanke et al (1999) for

analysing inflation targeting. However, there are not just theoretical grounds for inflation,

in the long run, being a monetary phenomenon. The empirical evidence available for the

euro area also suggests that the price gap is a relevant variable for explaining the dynamics

of inflation. Whereas price adjustment in the Taylor model is determined by the degree of

capacity utilisation, in the P-star approach it depends on the difference between effective

money holding and that desired in the long term. Below, small macro-models are used to

illustrate for a closed economy the implications which the inclusion of the price gap in the

Phillips relationship has for the transmission process of monetary policy impulses and the

efficiency of monetary policy.

3.1 Taylor model: Following Taylor (1999), a small stylised Neo-Keynesian macro-

model is described by the following three equations9

(3.1) y t = y*t − α (i t − ∆p t − r ) + ε t

(3.2) ∆p t = ∆p t −1 + η ( y t − y*t ) + υ t

(3.3) i t = r + πˆ + g (∆p t −1 − πˆ ) , α , η, g ≥ 0

where (3.1) is an aggregate demand function, (3.2) is a simple Phillips relationship for

inflation dynamics and (3.3) is a monetary policy reaction function. The nominal interest

rate i is simultaneously the monetary policy instrument variable, i.e. no distinction is made

between long and short-term interest rates.10 Furthermore, ∆p is the inflation rate, r the

(constant) real interest rate and π̂ the central bank's inflation target. Real demand depends

on the real interest rate, the inflation rate on the output gap, and the central bank's interest-

8 McCallum (2001) discusses "monetary policy analysis without money", Clarida et al (1999) treat the

"science of monetary policy" with a model in which neither money demand not money supply occur.

9 Clarida et al (1999) discuss a similar model with forward-looking expectations.

10 Baltensperger (2000) and Hetzel (2000) criticise this and other assumptions of the Taylor model.

–9–

rate policy reacts to observed deviations from the inflation target, i.e. it is a form of direct

inflation targeting. The demand shocks (ε) and price/supply shocks (υ) are non-

autocorrelated and distributed independently with zero mean and constant variances.

In the long-run equilibrium (if it exists) y = y*, ∆p = πˆ and i = r + πˆ . So that the inflation

rate is identical in equilibrium with the inflation target, it is crucial that the central bank

uses the "true" real interest rate (r) in the reaction function. If the constant term in the

reaction function diverges from the real interest rate, the system – even if it is stable – will

tend to an equilibrium value that may deviate sharply from the inflation target.11 The

money stock does not play an active role in this model. The model could be supplemented

by a money demand function, which would not make the slightest difference to the results.

Monetary policy impulses are transmitted solely via the interest rate and the output gap to

the inflation rate. The model (3.1 - 3.3) produces, as a reduced form for the inflation rate,

the following dynamic relationship12

1 − ηα g 1

(3.4) ∆p t = πˆ + (∆p t −1 − πˆ ) + ωt

1 − ηα 1 − ηα

How strongly the central bank reacts to deviations from the monetary target is crucial to

the stability of the Taylor model. Given a passive monetary policy (g = 0) , the coefficient

of the lagged inflation rate is greater than one. Thus, the process (3.4) is dynamically

unstable. But even a moderate active monetary policy with 0 < g ≤ 1 is not enough to

stabilise the inflation process. The system can be stabilised only if the central bank reacts

disproportionately (g > 1) to deviations from the inflation target. This is necessary in order

for an interest-rate increase to bring about a rise in the real interest rate. Interest-rate policy

is all the more effective, the more interest-elastic the demand for goods is and the more

strongly the inflation rate reacts to changes in the output gap. The system is dynamically

unstable if even only one of the three conditions fails: g > 1 , α > 0 , η > 0 .

11 If the central bank sets the real interest rate at ro ≠ r, the equilibrium inflation rate is then

π o = πˆ + ( r − ro ) /(g − 1) . If g lies in the proximity of one, small errors in the estimation of the real rate of

interest may lead to major deviations in the inflation target. Monetary policy then possesses an

inflationary or deflationary bias, even if it does not pursue an output target deviating from potential

output.

12 Laidler (2002) discusses the introduction of the money stock into the equation for real demand in the form

of a real balance effect or a credit channel. This would, however, make no change to the fact that

monetary policy acts only through one channel: real demand.

– 10 –

In an empirical study for 17 industrial countries, Goodhart and Hofmann (2000) estimate

aggregate demand equations (IS curves) and price equations (Phillips curves). This reveals

that, although inflation dynamics in most countries depend on the output gap, interest-rate

policy impulses do not even overcome the first hurdle of the transmission channel "since it

was not possible in almost all cases to detect any significant effect of the short-term real

interest rate on the output gap" (p 16). Nelson (2001) describes this evidence as the IS

puzzle. In contrast, Favara and Giordani (2002) provide evidence that money demand

shocks have substantial and persistent effects on output and prices. The suitability of the

Taylor model as a standard model for analysing monetary policy is therefore called into

question also from an empirical point of view.

3.2 P-star model: The P-star model incorporates the money market into the analysis

and assigns an active role to the money stock. Prices react to changes in the output gap and

the liquidity gap, i.e. to disequilibria on the goods and money markets. In formal terms, the

P-star model is obtained if the output gap is replaced by the price gap in equation (3.2) of

the Taylor model and equation (2.6) for the price gap is added:

(3.1) y t = y*t − α (i t − ∆p t − r ) + ε t

(3.2') ∆p t = ∆p t −1 + η (p*t − p t ) + υ t

(3.3) i t = r + πˆ + g (∆p t −1 − πˆ )

1 − η(αβ + γ )g 1

(3.6) ∆p t = πˆ + (∆p t −1 − πˆ ) + ωt

1 − ηαβ 1 − ηαβ

model, monetary policy acts through two channels. The first transmission channel runs

from interest rates via the real demand for goods and the output gap to the inflation rate. In

the second transmission channel, interest rates have an impact on inflation dynamics via

money demand and the liquidity gap.

With a passive monetary policy, the P-star model is also unstable. In this model, however,

no disproportionate reaction of the nominal interest rates is needed to stabilise the system

when there are deviations from the inflation target. In fact, it is sufficient if:

– 11 –

αβ

(3.7) g>

αβ + γ

Thus, values for the monetary policy reaction coefficient which are smaller than one can

stabilise inflation.13 By way of illustration, the following parameter values are assumed:

Income elasticity of money demand: β = 1.3

Interest elasticity of money demand: γ = 0.7

Reaction of inflation to disequilibria: η = 0.2

This calibration is broadly consistent with empirical estimation results for the Euro area.

Estimated interest elasticities of demand range from values insignificantly different from

zero (Goodhart and Hofmann 2000) to values close to one (Scharnagl 2002). The long run

income elasticity and interest rate elasticity of money demand is based on estimates for the

macro-econometric multi-country model of the Deutsche Bundesbank (2000). The reaction

of the rate of inflation to changes of the output gap and the price gap, respectively, are

consistent with estimates of Goodhart and Hofmann (2000), Smets (2000), Gerlach and

Svensson (2001), and Scharngal (2002).

This yields the stability condition: g > 0.48. In contrast to the Taylor model, in the P-star

model stabilising and controlling inflation by means of interest-rate policy is also possible

if the demand for goods does not depend on the real interest rate (α = 0). Conversely, the

stability condition of the Taylor model is obtained as a special case if money demand is not

dependent on the interest rate (γ = 0).

In both models, provided they are stable, the deviations of the inflation rate from the

inflation target follow a first-order autoregressive process:

(3.8) ∆p t − πˆ = Ω (∆p t −1 − πˆ ) + θ ωt

The parameters Ω and θ are given in equations (3.4) and (3.6) for the Taylor model and the

P-star model, respectively. Given otherwise identical parameter values, the persistence of

the inflation process in the Taylor model is higher than in the P-star model. However, in

the P-star model, the inflation process also depends on money demand shocks, which is not

the case in the Taylor model. It is therefore not possible to make general statements on the

13 The second transmission channel may explain why estimated reaction coefficients are often smaller than

might be expected for monetary policy rules in the Taylor model; see Clarida et al (1999).

– 12 –

variance of the inflation process and the output process. The (unconditional) variance of

the inflation process given the independence of the shocks is:

θ2

(3.9) σ 2∆p = E(∆p − πˆ ) 2 = σω

2

1− Ω 2

2

In the Taylor model σ ω = η2 σε2 + σ 2υ , whereas σ ω

2

= η2β 2 σε2 + η2 σ 2u + σ 2υ results for the

P-star model. The variance of output is

(3.10) σ 2y = α 2 (Ω − g) 2 σ ∆

2

p + θ σϖ

2 2

For a numerical illustration, the same parameter values as those above are used.

Furthermore, the variance of the demand shock is standardised at 1, the variance of the

price shock is set at 0.5 (Smets 2001, Viñals 2001) and the variance of the money demand

shock is set at 2 (Deutsche Bundesbank 2000): σε2 = 1 , σ 2υ = 0.5 , σ 2u = 2 . Thus, the

persistence parameter of the Taylor (P-star) model becomes Ω = 0.94 (0.68). The variance

of the residuals of the reduced form for the inflation process thus amounts in the Taylor

model (P-star model) to σ 2ω = 0.54 (0.65). The higher variance in the P-star model is due to

the assumed high variance of the money demand shocks. Given g = 1.5, the following

values are produced for the variance of the deviations from the inflation target (inflation

variance) and the variance of the output gap (output variance):

P–star model 1.61 1.78

g = 1.5

Given the same reaction function, monetary policy in the P-star model is thus much better

able to stabilise the inflation process than in the Taylor model. The more effective

stabilisation of the inflation rate comes not at the expense of larger output fluctuations.

– 13 –

If the reaction parameter of monetary policy g is changed step by step, the line of efficient

strategies (efficient policy frontier) shown in Figure 1 is obtained. The upper line shows

the trade-off between inflation and output stabilisation for the Taylor model, whereas the

bottom line belongs to the P-star model. Accordingly, the trade-off in the P-star model

appears much more favourable than in the Taylor model. If inflation dynamics does not

depend on the output gap alone, but also on the liquidity gap, interest-rate policy for

stabilising the inflation and output process is clearly more effective. In the P-star model,

the money stock assumes the active role assigned to it by economic theory and empirical

evidence.

10

Variance of Inflation

6

Taylor

P-Star

4

0

1 2 3 4

Variance of output

In the P-star model, a policy of disinflation is associated with smaller output losses than in

the Taylor model. Such output losses are usually measured by the sacrifice ratio. The

sacrifice ratio (SR) expresses the cumulative loss in output given a sustained decline in the

inflation rate by 1 percentage point. Given a permanent lowering of the inflation target by

1 percentage point, there is a cumulative output loss of 1 / η percentage point in the Taylor

model, as may be seen from (3.2). The smaller the parameter η is, the more rigid is the

price-adjustment process, and the output losses are all the greater under the impact of

reducing the inflation rates.14 In the P-star model, the sacrifice ratio is:

14 Empirical sacrifice ratios for Germany are between 2 and 4; see Tödter and Ziebarth (1999). Buiter and

Grafe (2001) analyse disinflation programmes using the sacrifice ratio.

– 14 –

1 α(g − 1)

(3.11) SR =

η αβ (g − 1) + γ g

As can be seen, for γ = 0 and β = 1 the sacrifice ratio of the Taylor model is obtained as a

special case. Since the second factor in (3.11) is invariably smaller than one, a

disinflationary policy in the P-star model is associated with smaller output losses than in

the Taylor model. In contrast to the Taylor model, the sacrifice ratio does not depend only

on the persistence parameter η, but also on the other structural coefficients of the model.

With the previously used parameter values, a sacrifice ratio of 0.91 is obtained, compared

with 5.00 in the Taylor model. The smaller output losses of a reduction in the inflation

rates is due to the fact that monetary policy in the P-star model has an impact on price

developments not only via the output gap but also via the liquidity gap. Table 3.2 gives the

sacrifice ratios in both models for some parameter combinations. As can be seen, a stronger

reaction by the central bank to deviations from the inflation target (g) leads to a rise in

disinflationary costs. A smaller persistence of the inflation process leads – as in the

Taylor model – to a decline in the sacrifice ratio.

g = 1.5 1.82 0.91 0.61

P-star model g = 2.0 2.44 1.22 0.81

g = 2.5 2.75 1.38 0.92

α = 0.5, β = 1.3, γ = 0.7

3.3 Empirical evidence: The P-star model has empirical relevance under two

conditions: a stable long-term money demand function and inflation dynamics driven by

the price gap. This requires that the monetary overhang (u) and the price gap (p* - p) are

stationary.

Since its development by Hallman et al (1989, 1991), the P-star approach has been

investigated in numerous empirical analyses. Hallman et al already noted for the United

States that the price gap is a better indicator of inflationary pressure than a series of other

criteria. This led to considerable interest in this concept in other industrial countries. The

P-star concept was studied in depth at the Bundesbank (Deutsche Bundesbank 1992, Issing

1992, Tödter and Reimers 1994, Issing and Tödter 1995). The P-star approach was also

subjected to empirical tests in other OECD countries, including by Tatom (1991), Hoeller

and Poret (1991), Kole and Leahy (1991), Atta-Mensah (1996). The results were generally

encouraging (Bank of Japan, 1990, p 5): "In sum, the price gap can be considered useful as

– 15 –

a simple yet comprehensive indicator of potential upward pressure on prices." Recently,

Herwartz and Reimers (2001) tested the P-star approach with a comprehensive database

from 110 countries for the period from 1960 to 1999. The panel–cointegration approach

used provides evidence for the existence of cointegration relationships between p and p*,

both for the entire sample and separately for the OECD countries and the countries of Latin

America.

The empirical evidence also supports the hypothesis of a stable relationship between the

money stock and prices in the euro area (Fagan and Henry 1998, Coenen and Vega 2001,

Brand and Cassola 2000, Müller and Hahn 2001). Recently, the P-star concept has also

been applied to explaining inflation dynamics in the euro area (Scheide and Trabandt 2000,

Gottschalk and Bröck 2000, Gerlach and Svensson, 2001, Trecroci and Vega 2000,

Altimari 2001). Although the euro area was not characterised by a single monetary policy

(albeit a coordinated one) during the sample period of these studies, it is apparent that the

P-star concept – despite considerable data uncertainty and aggregation problems – has a

notable explanatory power for aggregate inflation development in the euro-area countries.

For example, Gerlach and Svensson (2001) using aggregated quarterly data for the euro

area from 1981 to 1998 estimate a long-term money demand function and an equation for

price dynamics, where π = ∆p − πˆ :

(3.12)

π t = 0,35 π t −1 + 0,28 (p*t −1 − p t −1 ) + δ z t + res

(0,10) (0,05)

The variable z represents the rates of change in the energy prices. The coefficient of the

price gap is statistically highly significant. The output gap possesses no information

content for the development of inflation that goes beyond what is explained by the price

gap. Gerlach and Svensson (p 2) summarise the results of their study as follows, "... we find

that the so-called P* model has substantial empirical support. Thus, the 'price gap' ...

contains considerable information about the future path of inflation. Furthermore, and

perhaps surprisingly, the real money gap (i.e. price gap) has more predictive power than

the output gap." Scharnagl (2002) arrives at similar findings in a recent study on the P-star

approach for the euro area. Fase (2001) also finds a highly significant contribution of the

price gap to inflation dynamics in the euro area. These empirical findings confirm the

existence of a stable long-term money demand function and underline the importance of

the price gap in explaining price dynamics for the euro area.

– 16 –

4. Monetary policy rules in the P-star model

inefficient solely because it assigns a prominent role to

monetary growth and monetary analysis seems to me to

be inadequate and without justification when put in that

form." (our translation from Baltensperger 2001)

The last chapter investigated the relative efficiency of monetary policy in the Taylor and

P-star models given a strategy of direct inflation targeting. In this chapter, the P-star model

is used to analyse various monetary policy strategies. The following model is considered:

(4.1) y = −α(i − π − ρ) + ε

(4.2) π = λ π −1 + η q + υ

(4.3) q = β y − γ (i − ρ) + u

(4.4) µ = π + q − q −1

Time indices have been omitted to simplify notation, potential output has been

standardised at zero, the price gap is designated by q. Furthermore, the equilibrium

nominal interest rate has been abbreviated to ρ = r + πˆ and the deviations from the

inflation target to π = ∆p − πˆ .

The demand equation (4.1) corresponds to equation (3.1). The inflation equation (4.2) is

based on the more general form ∆p = E(∆p) + η q + υ , with expectations being formed at

the end of the period t-1 for the period t. Individuals' inflation expectations depend on the

most recently observed inflation rate and the central bank's inflation target:

E(∆p) = λ∆p −1 + (1 − λ) πˆ . For λ = 1, inflation expectations are backward looking, for

λ = 0 they are geared solely to the central bank's inflation target. Combining both

hypotheses produces (4.2). Equation (4.3) defines the price gap on the basis of the long-

term money demand function. In line with (2.1), the rate of growth of the money stock is

∆m = ∆p + ∆( β y − γ i + u ) . By analogy, the monetary target is defined as

µˆ = πˆ + ∆ ( β y * − γ ρ) . The deviations from the monetary target (µ = ∆m − µˆ ) may

therefore be written as in (4.4) as the sum of the deviations from the inflation target and

changes in the price gap. A monetary policy reaction function has been omitted for the time

being; it is replaced below by alternative loss functions for monetary policy.

– 17 –

In this model, monetary impulses are transmitted through two channels: via real demand

for goods and via money demand. The monetary channel is effective if the interest

elasticity of money demand differs from zero. The real channel is effective if the interest

elasticity of the demand for goods differs from zero. As a reduced form of the P-star model,

(4.5) is obtained:

π = λθ π −1 − θψ (i − ρ) + θ ω

y = αλθπ −1 − α(1 + θψ )(i − ρ) + θ ϖ

(4.5)

q = αβλθπ −1 − Ξ(i − ρ) + βθ ϖ + u

µ = (1 + αβ)λθπ −1 − (Ξ + θψ)(i − ρ) − q −1 + θω + βθ ϖ + u

ω = ηβε + ηu + υ

(4.5‘)

ϖ = ε + αη u + αυ

First of all, a passive monetary policy is analysed, where the central bank pegs the interest

rate at its equilibrium level (i = ρ) and does not attempt to make a stabilising intervention

in the system.15 In this benchmark strategy, the variance of the inflation rate amounts to:

θ2σω

2

(4.6) σ π2 =

1 − λ2 θ2

Given the structural parameters of the model, the inflation variance is all the higher, the

higher the variance of the shocks and the higher the persistence of the inflation process are

2

(σ ω , λ ) . In principle, these two factors provide handles for the central bank to conduct an

active stabilisation policy: Information on the dynamics of the systems and/or an

information advantage over individuals about the realisation of future shocks may help to

reduce inflation variability. If, moreover, the structural parameters are known, the central

bank can choose the strength of its reaction optimally.

4.1 Inflation targeting: What stabilisation effect can be achieved if the central bank

conducts an active interest-rate policy with the sole objective of stabilising inflation by

minimising the loss function L = E(π 2 ) ? The following reaction function is obtained:

15 Owing to the introduction of the persistence parameter λ, the P-star model is stable even with a passive

monetary policy if λ < 1 - ηαβ.

– 18 –

(4.7) i =ρ+

1

[λθπ−1 + θ ωˆ ]

θψ

As (4.5) shows, the expression in the square bracket is the conditional inflation forecast for

period t: E(π / i = ρ) , where ω̂ is the forecast by the central bank of the reduced form

inflation shock term. The parameter 1/θψ, which is dependent on all structural parameters

of the model, states the optimum intensity of the reaction to the forecast deviations from

the inflation target.

If the central bank is able to observe the shocks in period t before it fixes the interest rate, it

will have an information advantage over individuals (asymmetric information) and acts

with perfect foresight: ω̂ = ω . If the central bank has no information advantage (symmetric

information) it forms rational expectations about the level of the shock, i.e. its assumes

ω

ˆ = Eω = 0 . Both cases may be combined as ω̂ = κω . This formulation contains perfect

foresight (κ = 1) and rational expectations (κ = 0) as special cases, but also allows other

values for κ. If the reaction function is inserted into the reduced form for the inflation rate,

it follows that

(4.8) π = θ(1 − κ) ω

In other words, the deviations from the inflation target are either zero (perfect foresight) or

a pure random process with zero mean (rational expectations). The variance of the

deviations from the inflation target is:

(4.9) σ 2π = θ 2 (1 − κ) 2 σω

2

With perfect foresight, the central bank is in the position to eliminate fluctuations in the

inflation rate completely. Predictions of the level of the shock reduce the inflation variance

if 0 < κ < 2. In other words, the forecasts must not underestimate or overestimate the scale

of the shock by more than 100%. Measured by inflation variance, the optimum policy is

more efficient than the passive policy if the following condition is met:

The central bank can stabilise the inflation process successfully if the inflation rates display

a certain persistence or if it possesses information on possible realisations of the shock.

– 19 –

Inflation forecast targeting is an heuristic rule in which monetary policy is geared to

conditional inflation forecasts but the intensity of the reaction is decided on an ad hoc

basis:

(4.11) i = ρ + g (λθπ −1 + θω

ˆ)

θ2σω

2

(1 − gψθκ) 2

(4.12) σ π2 =

1 − λ2 θ2 (1 − gψθ) 2

For g = 0, the variance of the passive interest-rate policy results as a special case, whereas

for g = 1/θψ the variance of the optimum policy is obtained.

In direct inflation targeting, monetary policy is geared solely to observed deviations from

the inflation target, to which it reacts with an intensity decided on an ad hoc basis (gλθ):

(4.13) i = ρ + g (λθ π −1 )

θ 2σ ω

2

(4.14) σ π2 =

1 − λ2 θ2 (1 − gψθ) 2

If the central bank does not possess any information on the level of future shocks, direct

inflation targeting – depending on the choice of the reaction parameter – may even be more

effective than inflation forecast targeting but, at most, equally as effective as optimum

inflation targeting. These three inflation-targeting strategies differ in terms of the

information set used. In the case of optimum inflation targeting, the central bank's

information set consists of the equilibrium nominal interest rate, the structural parameters

of the model and the inflation forecast, which is derived from the reduced form:

(ρ , g*, Eπ) . Inflation forecast targeting uses an ad hoc reaction parameter and the inflation

forecast (ρ , g , Eπ) . Direct inflation targeting is based on past observations16 of the

inflation rate (ρ , g , π −1 ) . Some numerical calculations will illustrate these results, where

λ = 2/3 is set and the same parameter values are used as in the preceding chapter.

16 These observations may be subject to later revisions of data. Orphanides (2001) investigates the impact of

data revisions on monetary policy rules.

– 20 –

Table 4.1: Performance of inflation targeting

i = ρ + g(λθπ −1 + θω

ˆ) g

Inflation Output Inflation Output

variance variance variance variance

Passive policy 0 2.07 1.82 2.07 1.82

targeting

Inflation forecast 2.00 0.13 1.13 0.93 1.87

targeting

0.50 - - 1.47 1.54

Direct inflation 1.00 - - 1.19 1.53

targeting 2.00 - - 0.93 1.87

3.22 - - 0.86 2.82

4.00 - - 0.89 3.85

2 2 2

α = 0.5, β = 1.3, γ = 0.7, η = 0.2, λ = 2/3, σ ε = 1, σ υ = 0.5 , σ u = 2 .

The table above gives an overview of the stabilisation results of various forms of inflation

targeting. The optimum policy requires a forceful reaction to expected deviations from the

inflation target. As a result, the inflation variance can be significantly reduced (or

completely eliminated) compared with the passive policy. However, this is linked –

especially in the case of rational expectations – with a distinctly higher variance of the

output process. A reaction parameter of 2 was assumed for inflation forecast targeting.17

This leads to a distinctly lower output variance than with the optimum policy without

inflation variance being significantly increased. Direct inflation targeting is geared only to

the observed inflation rate of the preceding period. Compared to a passive policy, even

moderate reactions by interest rates lead to clear stability successes in inflation and output.

4.2 Price level targeting: Given optimum inflation targeting, the price level follows

the process

t

(4.15) p t = p o + t πˆ + θå (ω j − ω

ˆ j)

j=1

17 Given the selected parameter values, 2λθ roughly corresponds to the value 1.5 frequently used in the

analysis of Taylor rules. The optimum reaction to deviations from the inflation target in the preceding

period is, by contrast, 3.22 λθ = 2.47.

– 21 –

The unexpected inflation shocks accumulate in the price level. This results in the variance

of the price level becoming ever greater: σ 2p = t σ 2π . The price level is not determined in

t

the long term. As an alternative to inflation targeting, the literature therefore discusses the

targeting of the price level.18 Assume that the loss function of the central bank is:

1 1

(4.17) i =ρ+ (λθπ −1 + θω

ˆ)+ (p − p̂) −1

ψθ ψθ

This rule differs from the optimum rule for inflation targeting (4.7) in the last term. Price

level targeting requires the central bank to react to past deviations from the price level

target with the same intensity as to expected deviations from the implied inflation target.

With price level targeting, the following process results for the inflation rate:

(4.18) π = θ(ω − ω

ˆ ) − (p − p̂) −1

If the central bank pursues the strategy of price level targeting from the period t = 1

onwards,

π1 = θ(ω1 − ωˆ 1)

(4.19)

π t = θ(ωt − ω

ˆ t ) − π t −1 , t = 2 , 3 , ....

is obtained for the inflation rates. On the assumption that the shocks are not autocorrelated,

the variance of the inflation rates under price level targeting thus becomes:

σ 2π = θ 2 E(ω − ω

ˆ )2

(4.20)

σ 2π = 2 σ 2π ; t = 2 , 3 , ...

t

Apart from the first period, the variance of the inflation process under price-level targeting

is twice as large as in inflation targeting. In price level targeting, the price level follows the

process

– 22 –

(4.21) p t = p o + t πˆ + θ(ωt − ω

ˆ t)

i.e. there is no accumulation of the shocks. The variance of the price level is thus

(4.22) σ 2p = θ2 E(ω − ω

ˆ ) 2 = σ 2π

Price level targeting thus ‘buys’ the long-term stabilisation of the price level with a

variance of the inflation rates that is twice as high. With the chosen parametrisation of the

model, there is also a considerable increase in the variance of the output process. Table 4.2

compares the two strategies for the case of rational expectations (ωˆ = 0) .

Inflation targeting 0.86 →∞ 2.82

Price level targeting 1.72 0.86 12.39

ˆ = 0.

.

4.3 Taylor rule, monetary targeting and two-pillar strategy: So far, only

strategies that are oriented to one target have been considered. More general strategies may

be derived from the loss function

(4.23) L = E(π 2 + Φ y y 2 + Φ µ µ 2 + Φ i (i − ρ) 2 )

The first two terms take account of deviations from the inflation and output target that are

usually contained in monetary policy reaction functions. The third term captures deviations

from the monetary target. Even if rates of monetary growth are regarded as an intermediate

objective and not as the final objective of monetary policy, the incorporation of this term

into the loss function may be justified by the fact that inflation, in the long run, is a

monetary phenomenon and that the central bank cannot be indifferent to the rates of

monetary growth. With the last term, interest-rate fluctuations are sanctioned. The

existence of such a term in the loss function can explain why central banks make graduated

interest-rate changes (interest-rate smoothing). This term results in the reaction to the target

variables being generally more subdued. (For Φi → ∞ the passive policy (interest rate peg)

is obtained as a special case.) The optimum rule which follows from such an approach is

complex and difficult to communicate to the general public. In practice, therefore,

preference is often given to simple and transparent rules.

– 23 –

The Taylor rule is a strategy in which the central bank is oriented both to inflation and to

output. To derive the optimum Taylor rule, the loss function

1

(4.24) L = E( π 2 + y 2 )

3

is assumed, i.e. the weight of the output target amounts to one-third of the weight of the

inflation target.

strategy for controlling inflation. The Bundesbank had the statutory mandate to support the

economic policy of the Federal Government and thus "to keep an eye" on other targets. In a

wider target system, in which the targeting of inflation is indeed a priority but not the sole

objective, a strategy of monetary targeting can be quite prudent, especially as such a

strategy is easily intelligible and can be easily verified by the general public. In the

following analysis, the monetary targeting strategy is geared solely to deviations of the

monetary growth from the monetary target, i.e. L = E(µ 2 ) .

In the two-pillar strategy, the European Central Bank sets both a reference value for

monetary growth and an inflation target. In formal terms, such a strategy may be derived

from the loss function L = E(µ 2 + π 2 ) , with the same weight accorded to each of the two

targets. In this formulation, the two-pillar strategy is a combination of monetary and

inflation targeting. On the one hand, it stresses the importance of the money stock for the

propagation of inflationary processes and, on the other, expresses the primary objective of

stable prices.

All the cited strategies result in optimum reaction functions for interest rates, which may be

expressed as follows:

(4.25) i = ρ + (g π π −1 + g q q −1 ) + (g υ υˆ + g ε εˆ + g u û )

The rules differ in the intensity with which interest rates react to past information

(π −1 , q −1 ) and expected shocks (υˆ , εˆ , û ) . Table 4.3 shows the optimum reaction

coefficients.

– 24 –

Table 4.3: Reaction coefficients of optimum strategies

Inflation targeting 2.47 0.00 3.70 0.96 0.74

Taylor rule 1.34 0.00 2.01 1.44 0.40

Monetary targeting 0.68 -0.54 1.02 0.96 0.74

Two-pillar strategy 0.73 -0.52 1.09 0.96 0.74

Inflation targeting reacts sharply to observed deviations from the inflation target and to

expected price shocks. The reaction to output and money demand shocks is moderate. The

optimum Taylor rule requires, with a coefficient of 1.34, a reaction to observed deviations

from the inflation target which is close to the value of 1.5 common in the literature. The

rule involves a weaker reaction by central bank rates to observed deviations from the

inflation target and to expected inflation and money demand shocks than does inflation

targeting. The optimum reaction to goods demand shocks is, by contrast, stronger than in

inflation targeting. Monetary targeting implies an even weaker reaction to observed

deviations from the inflation target and to expected price and goods demand shocks than

does the Taylor rule. The reaction to money demand shocks, on the other hand, is greater.

Furthermore, this rule implies a negative reaction by interest rates to the lagged price gap.

This is due to the fact that the monetary growth depends negatively on the lagged price gap.

It is notable that the optimum reaction coefficients of the two-pillar strategy scarcely differ

from those of the monetary targeting strategy.

Table 4.4 shows what stabilisation results emerge with these rules in the case of the

variables inflation, output, monetary growth and interest rates, assuming that the central

bank possesses no information on the level of the shocks (ω ˆ = 0) . For comparative

purposes, the table contains two benchmark strategies. These are, first, the passive policy

and, second, a kind of meta-strategy resulting from the loss function

This loss function assigns the highest priority to the inflation target, followed by the output

target, the monetary target and the objective of stable interest rates.

Orientation solely to the inflation target leads to fluctuations of all the others variables

being significantly greater than in the case of a passive policy. The inflation variance is

halved, but the output variance is doubled and the variance of monetary growth rises

between three or four times. Additionally, there are considerable interest-rate fluctuations.

– 25 –

With a slightly higher inflation variance, the Taylor rule results in considerably smaller

fluctuations in the other variables. The monetary targeting strategy and the two-pillar

strategy differ from the Taylor rule by a halving of the variance of monetary growth,

whereas the fluctuations of inflation and output are greater.

Variance

Inflation Output Monetary Interest

growth rates

Passive policy 2.07 1.82 12.25 0.00

Inflation targeting 0.86 2.82 42.35 5.22

Taylor rule 0.97 1.75 20.05 1.76

Monetary targeting 2.48 2.59 8.82 1.65

Two-pillar strategy 2.25 2.44 8.86 1.60

Meta-strategy 1.61 1.77 9.77 0.69

ˆ =0

In Table 4.5, the features of the various strategies are summarised using the loss function

(4.23‘). In order to be able to assess the value of information on future shocks, both cases

- perfect foresight and rational expectations - are included. Given perfect foresight, the range

between both benchmark strategies is quite large. Even so, inflation targeting is an

exception in this context and records a loss that is greater than in the case of passive policy.

The Taylor rule performs considerably better. Nevertheless, the Taylor rule is itself

surpassed by both the monetary targeting strategy and the two-pillar strategy. This is due to

the fact that monetary growth is a "statistic" in which money demand shocks, output shocks

and price shocks are reflected. Both these strategies achieve a result which comes quite

close to that of the meta-strategy.

Passive policy 3.02 3.02

Inflation targeting 4.80 7.08

Taylor rule 1.65 3.65

Monetary targeting strategy 0.94 3.20

Two-pillar strategy 0.95 3.04

Meta-strategy 0.72 2.55

– 26 –

If the central bank does not have or does not use any information on future shocks, i.e. if it

operates under rational expectations, the leeway between the passive policy and the meta-

strategy becomes very tight. Given the selected parametrisation of the model, none of the

studied strategies succeeds in surpassing the passive policy solely on the basis of past

information. The monetary targeting strategy and the two-pillar strategy perform better than

the Taylor rule, however, and much better than inflation targeting.

Hitherto it has been assumed that, when fixing the interest rates, the central bank knows

either the realisations of the shocks (perfect foresight) or that it assumes their means

(rational expectations). Below, it is assumed that the central bank knows the monetary

growth rates before it fixes the interest rates, but that it does not have any information on

the realisations of the other endogenous variables. The reduced form for the deviations of

the monetary growth rates from the monetary target is given in equation (4.5). Owing to

(4.5), the central bank can prepare a conditional forecast for the deviation from the

monetary target:

(4.26) ~ = (1 + αβ)λθπ − q + w

µ −1 −1

In other words, the central bank is in a position to observe the linear combination

w = θω + βθϖ + u , but not the individual shocks. If the central bank fixes interest rates in

accordance with

1~

(4.27) i =ρ+ µ

Θ

where Θ = Ξ + θψ , it can then completely eliminate the deviations from the monetary

target.

Is this monetary growth rule perhaps even prudent if the central bank is interested only in

stabilising the inflation rates or possesses the Taylor loss function (4.24)? In actual fact, the

monetary growth rule (4.27) may be superior to these strategies if the central bank observes

w before it fixes the interest rates. The variance of the endogenous variables from Table 4.4

is reproduced in the first two lines of Table 4.6. The last column gives the minimised value

of the loss function (4.24). The third line shows the performance of the monetary growth

rule (4.27). This rule stabilises inflation and output better than inflation targeting or the

Taylor rule do. It may thus be prudent to use the available information on monetary growth

(i.e. a given linear combination of the output/price/money demand shocks) and pursue a

monetary growth rule as an intermediate target.

– 27 –

Table 4.6: Monetary targeting as an intermediate target strategy

Variance

Inflation Output Monetary Interest Loss*

growth rates

Inflation targeting 0.86 2.82 42.35 5.22 1.80

Given rational expectations

Taylor rule 0.97 1.75 20.05 1.76 1.56

Given rational expectations

Monetary targeting given information on 0.53 0.87 0.00 3.70 0.82

monetary growth

This paper analyses the price gap as an indicator for the development of inflation,

incorporates it into a small monetary macro-model – the P-star model – and investigates

various monetary policy rules in the context of this model.

On the basis of a long-run money demand function, three indicators of inflationary pressure

are discussed: the monetary overhang, the price gap and the nominal money gap. The price

gap is a comprehensive indicator of inflationary pressure, which combines information on

the goods market (output gap) and the money market (liquidity gap) and which can play a

major role in explaining inflation dynamics as part of an extended Phillips relationship.

Although inflation is widely regarded as a monetary phenomenon, the money stock does

not play an active role in the monetary transmission process in the nowadays widespread

Neo-Keynesian Taylor-type models. Monetary policy impulses have an impact on the

development of inflation solely through real demand and output gap. In the P-star model,

monetary policy impulses act on inflation dynamics via both real demand of goods and the

supply of liquidity. In this model, the central bank's interest rate policy is more effectively

in a position to stabilise inflation and output, and a policy of disinflation entails fewer

output losses. The empirical evidence available so far for the euro area supports the

existence of a stable long-term money demand and the relevance of the price gap for

explaining the development of inflation.

In an analysis of alternative monetary policy strategies in the context of the P-star model, a

number of variants of inflation targeting and a strategy of price-level targeting are first

considered. As becomes apparent, price level targeting does reduce uncertainty about the

long-term development of the general price level. This is, however, associated with a

doubling of the inflation variance and considerably greater fluctuations in the output gap.

– 28 –

Inflation targeting is a strategy which is geared solely to stabilising the inflation rates. If the

central bank has a target system in which other variables – such as output, the money stock

and interest rates – play a role alongside the inflation rate, more broadly based strategies,

such as the Taylor rule, monetary targeting or a two-pillar strategy are superior to inflation

targeting. The assumptions about the information set underlying the interest-rate policy

play an important role in how the various rules perform. Given certain information

assumptions, for example, monetary targeting as an intermediate targeting strategy may be

superior to inflation targeting or to a Taylor rule, even if the central bank's loss function is

only geared to stabilising inflation or inflation and output.

– 29 –

ANNEX A: The price gap as part of an indicator system for monetary policy

The P-star approach links disequilibria on the goods and money markets to form an

indicator of the potential for inflation. The equilibrium price level and the price gap can

also provide information on other markets, such as the labour market and the foreign

currency market, for example, and can be applied in structural analyses. The latter fact is

illustrated by the example of the breakdown of the general government balance into a

structural and a cyclical component.

Quantity Price

Money market M (v*)

Goods market y* p*

Labour market b* w*

Forex market - e*

λ = w + b − p − y (logarithmic), where W designates the wage rate (per employed person

or per hour worked per employee), B employment, P the general price level and Y output.

The equilibrium wage is expressed by w* = λ * + p * + y * − b * . This gives the wage gap

w * − w = (λ * −λ ) + (p * −p) − ( y − y*) + (b − b*) . Owing to (2.7), this expression may also

be written as

than in long-run equilibrium (distribution pressure), if cash holdings are higher than in

equilibrium (liquidity pressure) or if overemployment prevails (employment pressure).

According to this concept, wage pressure arises not only with overemployment but also if

there are distribution conflicts or excess liquidity.

FOREIGN EXCXHANGE MARKET: The starting point for an indicator of the foreign

exchange market is the real exchange rate q = e + p f − p , with Pf denoting the price level

abroad, E the exchange rate (units of the domestic currency per unit of the foreign

currency) and P the domestic price level. The equilibrium exchange rate as the relative

price of two currencies is then expressed by e* = q * + p * − p*f . The exchange-rate gap

corresponds to the relative price gap, adjusted for deviations from the real exchange rate:

– 30 –

(A.2) e * −e = (p * −p) − (p*f − p f ) + (q * −q)

A positive exchange-rate gap, i.e. pressure to depreciate on the domestic currency, arises if

the domestic price gap is larger than the price gap abroad (relative price pressure) or if the

real exchange rate is below its equilibrium level: in other words, if the domestic currency is

overvalued in real terms.

denoted by A, government receipts by S, the deficit by D = A-S and the nominal national

product by P Y, the deficit ratio d = D / PY may be approximated as follows: d = (a − s) θ ,

where θ = A / PY is the general government spending ratio. Primary government spending

is regarded as a positive function of the general price level, the real social product and the

unemployment rate:

(A.3) a = α p + β y + γ un + υa

The unemployment rate (un) is explicitly included, since a major part of the government's

transfer expenditure depends on the employment situation. Shocks on the level of

government expenditure are represented by the disturbance term υa. The expenditure

elasticities (α, β, γ) can be estimated by regression. A similar relationship is set up for

government receipts:

(A.4) s = δ(p + y) + υs

Since tax law is based on nominal variables, there is no need here to differentiate between

the elasticities. If, in (A.3) and (A.4), the variables are substituted by their equilibrium

values (p*, y*, un*) and the residual terms by their means (zero), the structural budget

deficit may be expressed as d* = θ (β − δ) y * + θγ un * + θ(α − δ) p * . The difference

between the current and the structural deficit ratio, i.e. the cyclical component and the

residual component of the budget deficit, is then the sum of the following factors:

In this equation, un* - un has been approximated by b – b*. If one assumes that the

elasticity of the tax system if greater than that of the expenditure system (δ > α, β), there

results an overshooting of the structural deficit (d > d*) if the capacities are underutilised,

if employment is low, if prices are below their equilibrium level or if a positive expenditure

shock or a negative income shock occurs. The deviations from the structural budget deficit

are linked to the goods market, the labour market and the money market, whereas

– 31 –

traditional approaches mostly take account only of the output gap and the unemployment

ratio (Ziebarth 1995, Mohr 2001). The table below provides a summary.

pressure pressure pressure

(y-y*) (v*-v) (b - b*)

Price gap (p*-p)

real exchange rate gap

Deficit gap (d-d*) Expenditure minus

income shocks

– 32 –

ANNEX B: On the fiscal theory of the price level

Recently, the explanation of prices as a monetary phenomenon has been challenged by the

fiscal theory of the price level (FTP)19, according to which the price level is determined by

the valuation equation for the nominal public debt (B):

∞

B t −1

(B.1) = E t å δ t , t + js t + j

Pt j= 0

In (B.1), δt,t+j is a stochastic discount factor and st+j denotes the real budget surpluses

(including seigniorage) without interest payments. The right-hand side of (B.1) is the

expected cash value of future budget surpluses. The valuation of public debt (B) is thus

performed in the same way as the valuation of private enterprises' shares.

Notwithstanding their differing appearance, the quantity theory and the FTP are not

mutually incompatible, but may be regarded as alternative ways of presenting a single

theory. If Y and V, for the sake of simplification, are regarded as exogenous and constant,

the quantity theory

(B.2) M t V = Pt Y

holds. The public sector (government and central bank) determines the level of public debt,

the quantity of money in circulation and the budget balance: {B t , M t , s t } . This

immediately produces the following problem: (B.1) and (B.2) are two equations with only

one unknown, Pt. It follows from this that fiscal policy {B , s} and monetary policy { M}

have to be coordinated in order to determine the price level (Sargent, 1986). Since both

relationships must hold in equilibrium, equilibria exist only for restricted sets of processes

for {B t , M t , s t } . In a fiscally dominated regime, the government makes the "first move,"

fixes { s t } and { B t } , and determines the price level via B.1. The central bank

accommodates this policy by providing the required quantity of money.20 In a monetarily

dominated regime, the central bank controls the money stock { M t } and thus determines

the price level. The government adjusts its surpluses { s t } in such a way that B.1 is met. In

19 Christiano and Fitzgerald (2000) as well as Carlstrom and Fuerst (2000) discuss the FTP in detail.

20 Cochrane (2000) shows for a cash-in-advance model that the valuation equation (B.1) alone can determine

the price level, even if no money demand exists, i.e. for V → ∞.

– 33 –

reality, there is not necessarily a sharp distinction between the two regimes.21 If the central

bank is independent and committed to the objective of price stability as in European

monetary union, however, the monetary regime predominates and the FTP becomes less

relevant in determining the price level, especially as the national fiscal policies are

embedded in the Stability Pact.

21 Sargent and Wallace (1981) study a fiscally dominated regime in which the central bank can exercise a

certain control over the path of the price level by having the choice between "inflation now" and "inflation

later". In this "unpleasant monetary arithmetic" regime, the government fixes the primary surpluses, but

does not attempt to compensate the receipts from money creation (seigniorage).

– 34 –

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The following papers have been published since 2001:

and Capital Formation Leopold von Thadden

of Central Banks be Published? Volker Hahn

Interests in Central Bank Councils Volker Hahn

Monetary Policymaking Henrik Jensen

Transparent about Economic Models

and Objectives and What Difference

Does it Make? Alex Cukierman

February 2001 What can we learn about monetary policy Andrew Clare

transparency from financial market data? Roger Courtenay

Dynamics Leopold von Thadden

Fund Managers – An Exploratory Analysis

of Survey Data Torsten Arnswald

on expected price developments for

monetary policy Christina Gerberding

and real exchange rate

in EU candidate countries Zsolt Darvas

– 42 –

July 2001 Interbank lending and monetary policy Michael Ehrmann

Transmission: evidence for Germany Andreas Worms

Montetary Policy Petra Geraats

konjunkturbereinigter Budgetsalden für

Deutschland: Methoden und Ergebnisse * Matthias Mohr

and Output: World-Wide Evidence Hans-Eggert Reimers

Exchange in a Search Economy Christopher J. Waller

Czech Republic, Hungary and Poland Franz Schardax

after a Decade of Transition Martin Summer

bank loans in Germany:

A panel-econometric analysis Andreas Worms

December 2001 Financial systems and the role of banks M. Ehrmann, L. Gambacorta

in monetary policy transmission J. Martinez-Pages

in the euro area P. Sevestre, A. Worms

New Perspectives on Financial Constraints

and Investment Spending Ulf von Kalckreuth

December 2001 Firm Investment and Monetary Trans- J.-B. Chatelain, A. Generale,

mission in the Euro Area I. Hernando, U. von Kalckreuth

P. Vermeulen

– 43 –

January 2002 Rent indices for housing in West Johannes Hoffmann

Germany 1985 to 1998 Claudia Kurz

ation, and EU Accession Lusine Lusinyan

to European Union in László Halpern

Pre-Accession Transition Countries Judit Neményi

German Banks Hannah S. Hempell

the cross-section of expected returns Jeong-Ryeol Kim

Process – Financial Instability and

Real Divergence Helmut Wagner

Based Densities of Foreign Exchange Joachim G. Keller

Application to Stock Market Returns Burkhard Raunig

German Interbank Market: Is there a Christian Upper

Danger of Contagion? Andreas Worms

lichen Haushalte in Deutschland – eine Ana-

lyse anhand der Generationenbilanzierung * Bernhard Manzke

to bank lending rates in Germany Mark A. Weth

– 44 –

April 2002 Dependencies between European

stock markets when price changes

are unusually large Sebastian T. Schich

for the Euro Area Hans-Eggert Reimers

dynamics of the current account Giovanni Lombardo

Between Firm Size, Growth, and

Liquidity in the Neuer Markt Julie Ann Elston

New Economy: Accelerated Depreci-

ation, Transmission Channels and Ulf von Kalckreuth

the Speed of Adjustment Jürgen Schröder

Exchange Rate Expectations –

Evidence from the Daily

DM/US-Dollar Exchange Rate Stefan Reitz

in the P-star model Karl-Heinz Tödter

– 45 –

Visiting researcher at the Deutsche Bundesbank

The Deutsche Bundesbank in Frankfurt is looking for a visiting researcher. Visitors should

prepare a research project during their stay at the Bundesbank. Candidates must hold a

Ph D and be engaged in the field of either macroeconomics and monetary economics,

financial markets or international economics. Proposed research projects should be from

these fields. The visiting term will be from 3 to 6 months. Salary is commensurate with

experience.

Applicants are requested to send a CV, copies of recent papers, letters of reference and a

proposal for a research project to:

Deutsche Bundesbank

Personalabteilung

Wilhelm-Epstein-Str. 14

D - 60431 Frankfurt

GERMANY

– 46 –