Target Level and Variability Trade-Offs

Abstract

Kydland and Prescott (1977) observe that optimal policy proves time inconsistent because of rational expectations. This paper shows that the issue of time inconsistency also arises from fewer policy instruments than targets. Fewer instruments, as is well known, lead to the issue of target controllability (Tinbergen, 1963). Accordingly, this paper investigates these two long-standing policy issues -- target controllability and time inconsistency, using the hybrid new-Keynesian model (Clarida et al., 1999). This paper finds that to address the time inconsistency issue, policy makers must first address target controllability, and that a proper target level trade-off solves target controllability, whereas a proper relative weight between target stabilizations achieves optimal target variability trade-off and solves time inconsistency. Other main results include the following. This paper derives a necessary and sufficient condition for joint asymptotic controllability of target values. The condition, which we call the long-run target level trade-off equation, is identical under commitment and under discretion. When the time-inconsistency problem does not exist, the central bank must make the same target variability trade-offs as society desires.

Keywords: Target controllability, Time inconsistency, Optimal policy, Discretionary policy, Target level, Target variability, Trade-off

JEL Classification: E52, E58