PREFACE xiii

Chapter 1. The Return of Monetary Rules 1

1. The Importance of Price Stability 4

1.1 Toward a New "Neoclassical Synthesis" 6

1.2 Microeconomic Foundations and Policy Analysis 10

2. The Importance of Policy Commitment 14

2.1 Central Banking as Management of Expectations 15

2.2 Pitfalls of Conventional Optimal Control 18

3. Monetary Policy without Control of a Monetary Aggregate 24

3.1 Implementing Interest-Rate Policy 25

3.2 Monetary Policy in a Cashless Economy 31

4. Interest-Rate Rules 37

4.1 Contemporary Proposals 39

4.2 General Criticisms of Interest-Rate Rules 44

4.3 Neo-Wicksellian Monetary Theory 49

5. Plan of the Book 55

PART I

Analytical Framework

Chapter 2. Price-Level Determination under Interest-Rate Rules 61

1. Price-Level Determination in a Cashless Economy 62

1.1 An Asset-Pricing Model with Nominal Assets 64

1.2 A Wicksellian Policy Regime 74

2. Alternative Interest-Rate Rules 85

2.1 Exogenous Interest-Rate Targets 86

2.2 The Taylor Principle and Determinacy 90

2.3 Inertial Responses to Inflation Variation 94

3. Price-Level Determination with Monetary Frictions 101

3.1 A Model with Transactions Frictions 102

3.2 Interest-Rate Rules Reconsidered 105

3.3 A Comparison with Money-Growth Targeting 106

3.4 Consequences of Nonseparable Utility 111

4. Self-Fulfilling Inflations and Deflations 123

4.1 Global Multiplicity Despite Local Determinacy 123

4.2 Policies to Prevent a Deflationary Trap 131

4.3 Policies to Prevent an Inflationary Panic 135

Chapter 3. Optimizing Models with Nominal Rigidities 139

1. A Basic Sticky-Price Model143

1.1 Pricesetting and Endogenous Output 143

1.2 Consequences of Prices Fixed in Advance 155

1.3 A New Classical Phillips Curve 158

1.4 Sources of Strategic Complementarity 163

2. Inflation Dynamics with Staggered Pricesetting 173

2.1 The Calvo Model of Pricesetting 177

2.2 A New Keynesian Phillips Curve 187

2.3 Persistent Real Effects of Nominal Disturbances 188

2.4 Consequences of Persistence in the Growth of

Nominal Spending 197

2.5 Consequences of Sectoral Asymmetries 200

3. Delayed Effects of Nominal Disturbances on Inflation 204

3.1 Staggered Pricing with Delayed Price Changes 207

3.2 Consequences of Indexation to Past Inflation 213

4. Consequences of Nominal Wage Stickiness 218

4.1 A Model of Staggered Wagesetting 221

4.2 Sticky Wages and the Real Effects of Nominal Disturbances 226

Chapter 4. A Neo-Wicksellian Framework for the Analysis of Monetary Policy 237

1. A Basic Modelof the Effects of Monetary Policy 238

1.1 Nonlinear Equilibrium Conditions 239

1.2 A Log-Linear Approximate Model 243

2. Interest-Rate Rules and Price Stability 247

2.1 The Natural Rate of Interest 247

2.2 Conditions for Determinacy of Equilibrium 252

2.3 Stability under Learning Dynamics 261

2.4 Determinants of Inflation 276

2.5 Inflation Stabilization through Commitment to a Taylor Rule 286

2.6 Inflation Targeting Rules 290

3. Money and Aggregate Demand 295

3.1 An Optimizing IS-LM Model 295

3.2 Real-Balance Effects 299

4. FiscalRequirements for Price Stability 311

Chapter 5. Dynamics of the Response to Monetary Policy 320

1. Delayed Effects of Monetary Policy 321

1.1 Consequences of Predetermined Expenditure 322

1.2 Habit Persistence in Private Expenditure 332

2. Some Small Quantitative Models 336

2.1 The Rotemberg-Woodford Model 336

2.2 More Complex Variants 345

3. Monetary Policy and Investment Dynamics 352

3.1 Investment Demand with Sticky Prices 353

3.2 Optimal Pricesetting with Endogenous Capital 357

3.3 Comparison with the Basic Neo-Wicksellian Model 361

3.4 Capital and the Natural Rate of Interest 372

PART II

Optimal Policy

Chapter 6. Inflation Stabilization and Welfare 381

1. Approximation of Loss Functions and OptimalPolicies 383

2. A Utility-Based Welfare Criterion 392

2.1 Output-Gap Stability and Welfare 393

2.2 Inflation and Relative-Price Distortions 396

3. The Case for Price Stability 405

3.1 The Case of an Efficient Natural Rate of Output 407

3.2 Consequences of a Mildly InEfficient Natural Rate of Output 411

3.3 Caveats 416

4. Extensions of the Basic Analysis 419

4.1 Transactions Frictions 420

4.2 The Zero Interest-Rate Lower Bound 427

4.3 Asymmetric Disturbances 435

4.4 Sticky Wages and Prices 443

4.5 Time-Varying Tax Wedges or Markups 448

5. The Case of Larger Distortions 455

Chapter 7. Gains from Commitment to a Policy Rule 464

1. The Optimal Long-Run Inflation Target 468

1.1 The Inflationary Bias of Discretionary Policy 469

1.2 Extensions of the Basic Analysis 476

2. OptimalResponses to Disturbances 484

2.1 Cost-Push Shocks 486

2.2 Fluctuations in the Natural Rate of Interest 501

3. Optimal Simple Policy Rules 507

3.1 The Optimal Noninertial Plan 510

3.2 The Optimal Taylor Rule 513

4. The Optimal State-Contingent Instrument Path as a Policy Rule 517

5. Commitment to an Optimal Targeting Rule 521

5.1 Robustly Optimal Target Criteria 522

5.2 Implementation of a Target Rule 527

Chapter 8. Optimal Monetary Policy Rules 534

1. A General Linear-Quadratic Framework 535

1.1 Optimal State-Contingent Paths 536

1.2 Alternative Forms of Policy Rules 543

1.3 Robustness to Alternative Types of Disturbances 547

1.4 Existence of Robustly Optimal Policy Rules 550

1.5 Optimal Instrument Rules 555

2. OptimalInflation Targeting Rules 559

2.1 A Model with Inflation Inertia 560

2.2 A Model with Wages and Prices Both Sticky 565

2.3 A Model with Habit Persistence 568

2.4 Predetermined Spending and Pricing Decisions 569

2.5 Optimal Policy for a Small Quantitative Model 573

3. Optimal Interest-Rate Rules 582

3.1 An Optimal Rule for the Basic Neo-Wicksellian Model 583

3.2 Consequences of Inflation Inertia 592

3.3 Predetermined Spending and Pricing Decisions 604

3.4 Optimal Policy under Imperfect Information 606

4. Reflections on Currently Popular Policy Proposals 610

4.1 The Taylor Rule 610

4.2 Inflation-Forecast Targeting 619

APPENDIXES

A: Addendum to Chapter 2 627

B: Addendum to Chapter 3 656

C: Addendum to Chapter 4 656

D: Addendum to Chapter 5 687

E: Addendum to Chapter 6 692

F: Addendum to Chapter 7 709

G: Addendum to Chapter 8 716

REFERENCES 747

INDEX 765