NBER WORKING PAPER SER~S

PRICE LEVEL TARGETING VS. TARGETING: A FREE LUNCH?

Lars E. O. Svensson

Working Paper 5719

NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 August 1996

Part of the work for this paper was done during a visit to the International Finance Division at the Board, Washington D. C., in July 1995, I am grateful to the Division for its hospitality. I thank George Akerlof, Alan Blinder, Guy Debelle, Jon Faust, Stanley Fischer, John Hassler, Dale Henderson, Miles Kimball, David Lebow, Frederic Mishkin, Torsten Persson, Carl Walsh and participants in seminars at the CEPR Workshop at IGIER, Milan, BES, Institute for Graduate Studies, Geneva, NBER Summer Institute Monetary Economics Workshop, Tilburg University, University of California, Berkeley, and University of California, Santa Cruz, for discussions and comments. I also thank Marten Blix for research assistance, and Maria Gil and Christina tinnblad for secretarial and editorial assistance. Expressed views as well as any errors and obscurities are my own responsibility. This paper is part of NBER’s research programs in International Finance and , and Monetary Economics. Any opinions expressed are those of the author and not those of the National Bureau of Economic Research.

O 1996 by Lars E. O. Svensson. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including O notice, is given to the source, NBER Working Paper5719 August 1996

PRICE LEVEL TARGETING VS. INFLATION TARGETING: A FREE LUNCH? WAGE

ABSTRACT

Price level targeting (without base drift) and inflation targeting (with base drift) are compared under commitment and discretion, with persistence in unemployment. Price level targeting is often said to imply more short-run inflation variability and thereby more employment variability than inflation targeting. Counter to this conventional wisdom, under discretion a price level target results in lower inflation variability than an inflation target (if unemployment is at least moderately persistent). A price level target also eliminates the inflation bias under discretion and, as is well known, reduces long-term price variability. Society may be better off assigning a price level target to the even if its preferences correspond to inflation targeting. A price level target thus appears to have more advantages than commonly acknowledged.

Lars E. 0, Svensson Institute for International Economic Studies Stockholm University S-106 91 Stockholm SWEDEN and NBER Lars,Svensson@iies .su.se 1 Introduction

“Priw stability” is often rmmmended as a god for . Price stability has been

interpreted in different ways, though. Price stability can be interpreted as ptia level stability,

that is, a stationary price level with low varianm. In practim, price stability h= often been

interpreted as low and stable infidion. As is well known, unless above-average ifiation is

followed by below-average inflation, this restits in base drift of the price level. Bsse drift in

the price level implies that the prim level kma non-trend-stationary, and the variance of the

future price level increases without bounds with the for~t horizon. This is obviously rather

far from literal prim stability. I shall refer to a monetary policy regime M prim level taqetzng

or infiattin taqei!ing, depending upon whether the goal is a stable pri~ level or a low and stable

itiation rate, where the latter allows base drift of the pri~ level.

In the real world, there are currently several monetary policy regimes with explicit or implicit

idation targeting (see Haldane (1995) and Leiderrnan and Svensson (1995)), but there are no

regimes with explicit or implicit price level targeting. Whereas the Gold Standard may be

interpreted as implying implicit price level targeting, Sweden during 1931-33 may so far have

been the only regime in history with explicit prim level targeting (cf. Fisher (1934) and Jonu.ng

(1979)).

Even if there are no current examples of prim level target regimes, prim level targeting

has received incre=ing in the monetary policy literature, and several recent papers

compare inflation targeting and price level targeting. Several papers are collected in Bank of

Canada (1994). Duguay (1994) summarims th~ papers and others and provides a thorough

discussion of the issues involved, see also Fischer (1994) and Gtiart and Vifials (1994). Some

papem compare ifiation and price level targeting by simulating the effect of postulated reaction

functions (Lebow, Wberts and Stockton (1992), Fillon and Tetlow (1994), Haldane and Salmon

(1995)). Other papem compare the properties of postulated simple stochastic processes for

inflation and the prim level (Duguay (1994), Fischer (1994)). A frequent restit, emerging as

the conventional wisdom, is that the choim between price-level targeting and inflation targeting

involves a trade-off between low-frequency price level unmrtainty on the one hand and high-

frequency ifiation and output uncertainty on the other. 1 Thus, price level targeting has the

1 The ~ult k emphasizedin Lebow, Robert and Stockton (1992), Ftier (1994), and Haldane and Salmon (1995). In mntrast, Fillon & Tetlow (1994) report that in their simu]atiom prim level targeting r~ults in less irdlationvariabilitybut in more output variability than Mation targeting. No explanation is offeredbeyond the observationthat the resultsindicatestrong serialmrrelation of the pricelevel. Duguay (1994) does not report the unmnditiond vtiance of one-period inflationrak in hi. examinationof d~erent procesa~ for inflationand the

1 advantage of reduced long-term variability of the prim level. This should be beneficial for long-

term nominal mntracts and intertemporal d~isions, but mmea at the cost of incremed short-

term variability of idation and output. The intuition is straightforward: In order to stabilize the

price level under price level targeting, higher-than-average ifiation must be sumeedd by lower-

than-average idation. This should rau.lt in higher ifiation variability than inflation targeting,

sinm in the latter H base level drift is accepted and higher-than-average i~ation need only

be su*d by average inflation. Via nominal rigiditi~, the higher ifiation variability should

then result in higher output variability,2

Applying poatulatd monetary policy reaction functions, ‘instrument rules’, evokes the issue

of whether these reaction tictions are optimal for reasonable objective functions of the cen-

tral bank, and whether they are consistent with the realistic situation when the central bank

acts under discretion and mmmitment to an optimal or a simple second-best rule (like those in

McCaUurn (1990) or Taylor (1994)) is not possible (cf. Laidler (1993)). Similarly, applying pos-

tulated pr~ses for ifiation and the price level evoka the issue of whether these are consistent

with a reasonable equilibria.

The purpose of this paper is to mmpare pri~ level and tiation targeting, but the pa-

per departs from the previom literature on price level veraus inflation targeting by applying a

principal-agent approach: the decision rules considered are the endogenous decision rules that

result when society (the principal) ~signa (delegates) an inflation target or a price level tar-

get to a central bank (the agent) scting under discretion. In mmparison, the mrresponding

endogenous decision rules under commitment are also reported, although the focus is on the

discretion case. The reaction functions are henm endogenous, given central bank objectives and

mnstraints, including available mmmitment technology.

The paper follows Svensson (1996) in interpreting inflation targeting 59 including an ex-

plicit iflation target and an implicit employment target, with an implicit relative weight on

employment stabilization. This is motivated by the existence of target bands in actual inflation targeting regimes, indicating that some short-term inflation variability may be ~ptable due

prioelevel, although for mme of the parametersstudied that varian~ is actually 1- under price level targeting (- the appendix h the presentpaper). 2 Hall (1984, 1986) provid= argumenfi for prim stability. McCallum (1990) argurs that price level targeting providesa relativelysmall gain in long run pricepredictabili~, sine primlevelvariability(for the U.S.) is already relatively small under inflation targeting. Gerlach (1993) interpretsinflation targets ss a ‘target zone’ for the pricelevel. Scarth (1994), Crawfordand Du~uier (1994), and Koni~ny (1994) buss variousaspeck of price targeting and inflationtargeting. Base drift in is distinct from base drift in the prim level. AS shown by Walsh (1986), ~me degree of money supply b- drift is warrantedeven with pria level stabfi~, if there are permanent shocks to money demand and output.

2 to imperfect mntrol over idation but perhaps also in order to dmpen employment fluctua-

tions; the fact that no inflation targeting central bad seems b behave as if it wants to attain

the inflation target at any coat (cf. Haldane (1995) and kiderman and Svensson (1995)); and

by wording in King (1995) that indicates that the inflation targeting is not

an “ifiation nutter” with zero weight on employment stabilization. Price level targeting is

consequently interpreted as including an explicit price level target, together with an implicit

employment target. 3

The paper considers the realistic ~ when output and employment is persistent. The degree

of persistence in employment is ind~ crucial for the results: Without persistence, a trivial

trade-off between long-term price level variability and short-term itiation variabilityy arises.

With at least moderate persistent, counter to the mnventional wisdom, there is no trade-off

between price level variability and inf4ation variability. Prim level targeting then results in

lower inflation variability than itiation targeting. This r~ult is due to the endogenous decision

rule that results under discretion for different targets. Under inflation targeting the decision

rule is a linear feed-back n..de for inflation on employment. Then the variance of tiation is

proportional to the varianm of employment. Under prim level targeting, the decision rule is a

linear feed-bd rule for the price level on employment. Then inflation is a linear function of the

first diflemna of employment. The varianm of ifiation is then proportional to the varianm of

the fist differenm of employment. With at least moderate persistent, the variance of the &t

differenm of employment is less then the variance of employment.

In addition, a prim level target has the advantage of eliminating any ifiation bias that

reatits under discretion if the employment target ex~s the natural rate of employment. It is repl~ by a harmless price level bias. kdeed, with at least moderate persistence, even if society prefers to minimize inflation variability rather than prim level variability, it will be better off by

=signing a prim level target to the mntral b~ rather than a itiation target. The variance of idation will be lower, there is no idation bias, and with expectations inmrporating price level targeting, employment variability will be the same as under idation targeting.4

3 Svenmon (1~) makes the point that inflationtargeting regim~ shodd be interpreted as having explicit unemploymentor output targeti, and mmpar~ inflation targeting regim~ to (1) Rogoff (1985) ‘consemative’ central banh with more weight on inflation stabilization, (2) ‘IiIIU itiation contr~’ proposed by Walsh (1995) and extinded by Pe~n and Tabellini (1993), ~d (3) ‘output targeting’ regimes, both with and without persistencein output and unemployment. For instana, without persisten~, an optimal ifiation target qual to the tially best tiation rate less any discretionarytiflation bias is identical to a linear inflation contract and better than a Rogoff ‘conservative’centralbank. 4 The coquences of downwardnominal rigidity and nonnegativenominal interestrates are dkti in the concluding~tion.

3 Section 2 presents the model with i~ation targeting. Section 3 introduces prim level target-

ing, Section 4 evaluatea price targeting equilibria with inflation targeting preferenms. Section 5

provides inclusions. An appendix pr~ents technical details, including some restits on exoge-

nous inflation a,nd priu level pr~ses.

2 Inflation targeting

The treatment of tiation targeting under peraistenm follows Svensson (1996), which in turn

builds on the recent extension of the analysis of rul~ and discretion in monetary policy to

the case of persistence in Lockwood and Philippopoulos (1994), Jomson (1995) and Lockwood,

Miller and Zhang (1995), The short-run Phillips curve is

where lt is (the log) employment rate in period t, o and p are mmtants (a >0 and O s p < 1), nt = pt —pt_ 1 is the (log of the gross) inflation rate, pt is the (log) prim level, n: denotes price level expectations in period t – 1 of the prim level in period t, and et is an i.i.d. supply shock with mean O and variance U2, The private sector has rational expectations. That is,

7r; = Ec_lfit, (2.2) where Et–1 denotes expectations conditional upon information available in period i! – 1, which includes the realization of all variablea Up to and including period t —1, as well as the constant parameters of the model. The short-run Phillips curve corresponds, for instance, to a situation in which nominal wagea for period t are set one period in advanw, b~ed on expect atiom in period t – 1, without knowing the supply shock Etin period t. The (long-run) natural employment rate, which I identify with the unmnditional mean of the employment rate, E[lt], is for mnvenience set equal to zero. The autoregressive term arisea, for instance, in wage setting models where trade unions set nominal wages one period in advanm, disregarding non-union workers’ preferences and only taking inti account union members’ preferences for real wages and employment, and where union membership dependa on previous employment.

The social preferences are repr~ntd by the social loss function

v = El-J~p~-lLt , (2.3) [mt=l 1

4 with the “period” loss tiction

L~ = ; [(7rt– T*)2+ A(l~ – 1*)2], (2.4)

The period loss function is characterized by three parameters: n“ is the socially best ifiation rate, 1● is the socially best employment rati, and A > 0 is the social weight on employment stabilization relative to inflation stabilization, The (log of the) smially best employment rate,

1“, is assumed to be at lesat m huge as the natural employment rate, hence 1“ 20. Then 1“ mn be interpreted aa a measure of the distortion in the labor market that causes the socially bat employment level to exmd the natural employment level. Alternatively, 1“ can be interpreted as a measure of the extent to which the employment target is overambitious. The role of the overambitious employment target in the analysis is to introduce a benefit from itiation surprises.

As noted in the literature, such benefits can also arise for other reasons, for instance, if a surprise real depreciation of the nominal public debt is less distortionary than explicit taxation. For the purpose of this paper, it is not crucial that the employment target is above the natural rate.5

The central bank is for simplicity assumed to have perfect mntrol over the ifiation rate Zt.

It sets the itiation rate in each period after having observed the current supply shock Ct.6

2.1 Commitment

The optimal rule under mmmitment is derived ss the solution to the problem

V-(lt-l) = mi; Et.l ; (7r, - m“)z + A (1~- 1“)2] + pv”(l,) (2.5) {[ } subject to (2.1) and (2.2). The lagged employment rate enters as a state variable. Here nt may depend on both the supply shock et md the lagged employment rate lt_l, whereas n; may only depend on lt_ 1. The indirect loss function V“ (lt_l) will be quadratic and can be written

1*2 V“(lC-l) = ~~ + vi~t-1 + ~722t-1. (2.6)

It is shown in the appendix that the optimal nde is

7rt = 7r*—b“e~ (2.7)

s Rsulk for 1- = O will be reportd in footnotes. c The resulti are not affectedif output is mnsideredthe mntrol variable; or (cf. ~goff (1985)) if an a~egate demand equationis also addedwhereaggregatsdemand dependson the realinte~t rate and the nominal intermt rate is the instrumentof monetary policy; or if a money demand quation is ab added and money supply is the titrument. A control erroron the price levelwill, however,affd the rmults mmewhat, ~ explained below.

5 where

(2,8) and Ap2 T;=1_pp2” (2.9)

The employment rate will then M

it= plt_~ +(1 – ab”)et. (2.10)

We see that the optimal i~ation response to supply shocks is larger under persistence (p >0,

~~ > O) than without (p = y; = O). Since.current employment changes affect future employment, it becomes more important to stabilize employment; hence ifiation is allowed to fluctuate more.

Note that inflation only depen& on the private information of the mntral bank; any dependence on information known by the private sector just goes into expectd itiation, which adds to the loss function without affmting employment; cf. Persson and Tabellini (1993).

The results are summarized in Table 1, the mlum.n for Commitment. tinditional and unconditional expeeted inflation equal the inflation target, rows (5) and (6). The conditional and unmnditional variance of tiation are equal and given in rows (7) and (8).

The future prim level is a random walk with drift,

T G, T>t, PT=Pt+(T-t)m* -b* x T=t+l and its andit ional variance will henu be increasing in the horizon, row (11). The unmnditional variance of the price level, row (12), is hence unbounded.

Long term itiation will be

PT-Pt E;=t+l ~~ , f-f> ~ =n*—b* ! T-t T-t with conditional and unmnditiona,l expectation equal to the inflation target, rows (14) and (15).

The mnditional variance of long term inflation will be dwreasing in the horizon, row (16), and equal to the unmnditional variance, row (17),

2.2 Discretion

Under discretion the decision problem of the mntral bank can be written

V(lt.l) = Et_l * ; (m, - 7r”)2 + A(lt - 1“)2] + pv(lt) , (2.11) {[ }

6 where the minimization in perid t is subject to (2.1) but is done for given ifiation expectations

n:. The mntral bank thus no longer internalizes the effect of its decisions on inflation expec-

tations, although it takes into -Unt that changes in current employment will affect current

expectations of future inflation (this is incorporated in ~(lt) ). The indirect loss function can be

mitten

v(i~_ ~) = ~~ + ~~it-1 + ;721;_1 . (2.12)

In the appendix it is shown that the decision rule and employment rate fulfi117 . h 7rt=a— -lt=&– — (2.13) I–ah 1 ~atpl’-l ‘6E”

(2,14)

The constants are given by

(2.15)

where Al” [1+ (A +@?2)~2] P < ~ (2.16) 71=–1–9p[1 +(A+~72)a2] – ‘

As explained in the appendix an existenm condition mwt be fu1611ed.s

The results under discretion are summarized in Table 1, the column for Discretion. The

decision rule an be written u a feedback rule on current employment, or as a function of

lagged employment and the current supply shock. Without persistent, that is, for p = O, we

have 72 = ~~ = O. Then the ifiation respom to supply shocks under discretion is the same as

the optimal rule, ~ = b“. With persistent, we have ~2 > y; (see appendix), and by mmparing

(2.15) and (2.8) we see that, under discretion, there is a stabilization bim in that the inflation

reapow to supply shocks is larger than the optimal rule,

6> b*.

Since under discretion the future inflation bias depends on the current employment rate, it be- mmes even more important to stabilize the employment rate, which requires a stronger inflation

7 The quilibrium mnqt is a Markov-perf~t equilibriumwheretriggerstrategiesare not allowedand actions depend on history only via the lagged state variable,U,-l (cf. Mood and Philippopoulos (1994)). a Ifu* =0, thed~ion ndehas~l =0, d= r”.

7 response. Thus, conditional and unconditional employment variability is lower under discretion

than under mmmitment, rows (2) and (3) in Table 1.

~nditional expectd idation is given in row (5). We see that the inflation bias, Etnt+l – n“, depends on lagged employment and is hence state-dependent. The average inflation bias,

is larger than the inflation bias Aal* without employment persistence.g

The mnditional and unconditional variance of inflation is higher under discretion, rows (7) and (8), sinm the itiation rate is a linear function of employment rather than of the supply shock.

The future price level is au I(1) process that -

and long-term tiation will be

Thus, expectations and varian~ of the future prim level and long-tern itiation in rows (14)-

(17) will depend on the expectations and variances of the sum and average of future employment ra~. These are reported in Table 2.

9 H 1’ = O, the avera~ inflationbim ia mm.

8 ~ble 1. Inflation targeting Commitment Discretion

(1) lt pit-l + (1 – ab”)et pit-l +(1 – a6)Et

(2) Vartlt+l (1 - ab”)zuz (1 – at)zaz

(3) Var [1~] w * (4) 7rt 7r*– b“ct a— % lt l–ah (5) Etnt+l 7r’ a—- I-habplt (6) E [rt] T* a

(7) vart7rt+l

(8) Var [nt]

(9) Pt

(lo) PT (11) var~pT

(12) Var ~t]

(13) ~

(14) Et~

(15) E [w]

(16) Vart~ b*2 #t (17) Var [1~ b*2&

Table 2. Expectation and variance of future employment under discretion (1) lT =

(2) zT=t+l J. =

(3) Et GT=t+l lr =

(4) V~tlT =

(5) Var [it] =

(6) Vart ~T=t+l 1, =

(7) Var [E:=t+l 1.] =

(8) iT–i~ =

(9) Var [lt – 1~-1] =

(lo) v= [ZT– ~t] =

9 3 Price level targeting

The Phillips curve (2. 1) can be written

ut=pt–l —~(Pt — P:) + ~tl (3.1)

since mt—n: = pt – P;, where P: denotes the expectation in period t – 1 of the (log) prim level

in period t. The private sector’s rational ex~tatiom imply

p: = Et_lpt. (3.2)

Under price level targeting, the period loss function is

(3.3)

where pj is the socially best (log) prim level, In order to be mnsistent with the socially best

inflation rate, the socially best prim level f~s

p; =p;_l +7r*. (3.4)

The previous ~sumption that the antral bank has perfect control over inflation implies

that it h= perfect mntrol over the price level. It sets the prim level in each period after having

observed the current supply shock et.10

3.1 Commit ment

Under cotitment to an opt imal tie the decision problem is

v*(l~_~) = rnin Et-1 {; [(P, -P;)2 + ~ (z, - 1“)’] + Pv”(lt)} (3.5) PtSC

10Nominal incometargeting has bmn examinedfor imtan~ in ~ (1983), in severalcontributionsin Bryant, Hooper and Mann (1993), in Hendersonand McKibbin (1993), in McCallum (1~), and more recently in Hall and Mankiw (1994). One haa to distinguishbetween targeting the level and the growth rate of nominal income. Nominal income leweltargetingwould in the presentframeworkm~pond to

where Yt and Yt” are (the log of) nominal inmme and ik target, Y~ = pt + yt, Yt- = P; + y“, and YLand Y” are (the log of) real output and iti target. ht for simplicityV, = l,. Then,

L; = ; y, - y’]~ = ; [~, -p;)’+ (1,–1”)2] +(,PL–p*)(l, - l=).

Thus, nominal inmme targetingis not exactly equal k price level targeting with A = 1; the cross term enters as well. The Werenm is, of cou~, that nominal iucome level targeting implies a mnatant unitary marginal rate of substitutionbetween the price level and the employment rate, regardl~ of the levelsof the variables.

10 subject to (3.1) and (3.2), The prim level ~ may depend on the lagged employment rate and

the current supply shock; expectations p: depend on the lagged employment rate only.

The decision problem is identical to that of an ifiation target under commitment, (2.5), exmpt that pt and p; replu Tt and T*. Thus the indirect 10SSfunction is unchanged. With the same reasoning ~ above, the optimal decision rule is

p~ = p; - b“e~, (3.6) with b“ given by (2.8). The employment rate will then ml (2.10).

The result is summarized in Table 3, the column for Commitment. The future prim level is no longer a random walk with drift but trend-stationary and given by

PT=P; -b*~T= ~+(T–t)m* –b*(eT– et), with conditional and unmnditional expectation equal to p; = p; + (T – t)m”, and mnstant mnditional and unconditional varianm, row (11) and (12).

Infiation fu1611s

Xt =pt —p~_l = n* —b*(ec —et–l).

The condition expected itiation is no longer constant, row (5), The unconditional variance of itiation is twim the conditional varianm, row (7) and (8),

brig-term ifiation is given by

● ET — et PT-Pt =r*—b — T-t T–t

The conditional expectation of the long-term inflation rate is given in row (14). The conditional and unmnditional variance is decreasing by the square of the horizon, row (16) and (17).

3.2 Discretion

Under discretion, the decision problem of the mntral bank can be written

v(lt_l) = Et-l ~n ~ (Pt-P;)2+A(it - 1“2) ] + Bv(lt) , (3.7) {[ } where the minimization in period t is subject to (2.1) but is done for given price level expect a- tions pf. Thus the central bank no longer internalizes the effect of its decisions on price level expect ations, although it takea into ~unt that changes in current employment will affect current expwtations of future pria levels (this is incorporated in ~(lt)).

11 Except for the change in variables from nt to pt, the decision problem is the same as under

itiation targeting. Thus, the indirect 10ssfunction will be the same w under ifiation targeting.

By the same argument as above the decision rule futills

i i pt=Gt– -lt=4– -pzt.l – &t, (3.8) I–ah l–ah

with

at= p; + Aal” – pa~~, (3.9)

where 6 is given by (2.15), ~1 and ~2 are given by (2.16) and (2.17), and the same existence

condition is med. The employment rate will behave as (2.14).

With persistence, the prim level response to supply shocks is larger under discretion than

under commitment. Sinm, under discretion, the future price level bias depends on current

employment, it becomes even more important to stabilize employment. This requires a stronger

prim level response. The price level under price level targeting behaves precisely as the inflation rate under inflation targeting, with an average and state-mntingent ptiu level bi= instead of an itiation bias.

The results are summarized in Table 3, the mlumn for Discretion. The future price level is b pT=&~– ‘lT. l-ah and dependa only on future employment, The conditional and unconditional variance are re- ported in row (11) and (12).

Mation will be given by A ~t=pt–pt_~=~”_ ~(lt - Zt.1), (3.10) where I have used (3,4). We see that there is no average ifiation bias under price level targeting, row (6), although there is a state-cent ingent inflation bias, row (5). The conditional variance of inflation is the same aa under tiation targeting, row (7), whereas the unmnditional varianm is different, row (8).

Indeed, comparing itiation under idation targeting and price level targeting, we note that inflation under inflation targeting is a linear function of employment (Table 1, row (4)), whereas under price level targeting it is a linear function of the first diffemnti of employment (Table 2, row (4)). The unmnditional varianm of these are by Table 2 related as

Var [it – 1~-~]= 2(1 – p)Var [1~].

12 Sinm the unconditional varianm of the fist difference of the employment rate is lower than the unconditional variance of output if p > ~, it follows that the unconditional variance of inflation is lower under prim level targeting if the employment rate is at least moderately persistent. If

1“ = O, p > ~ is both necessary and sticient for a lower varianm of ifiation under prim level targeting; if 1“ >0, p > ~ is sticient but not n~sary.

brig-term inflation is PT-Pt 6 iT–lt =7r*— —— T–t I_a~T–t’ and depends on the average differenm between future and current employment, ~, whereas under inflation targeting it depends on the average sum of future employment, E;:;l 17. The mnditional and unconditional variances are reported in Table 3, rows (16) and (17), cf. Table 2.

Table 3. Price level targeting brnmitment

(1) pit-l +(1 – ab”)ct

(2) var~lt+l (1 - ab”)zaz

(3) Var [it]

(4) Tt 7r*– b“(et– et_l)

(5) Etnt+l 7r*+ b*et

(6) E [nt] 7r*

(7) Vart7r~+l b*202

(8) Var [7rt] 2b*2u2

(9) Pt p; – b“et

(lo) m p; – b*&T (11) var~pT b*zuz

(12) VW bt] b*2u2 ~m—b*~ (13) w

(14) Et~ n’ +b*~

(15) E [w] T*

(16) Vart~ b“2~ (17) Var ~~1. ~ 2b*2(T-t)%‘2

13 4 Evaluation of price level target equilibria with ifiation target preferences

E social preferences mrrespond to the price level period 10SSfunction (3.3), it is obvious that a

price level target equilibrium is preferable to an inflation target equilibrium. The two equilibria

have identical employment behavior, but in the inflation target equilibrium the prim level is

non-trend-stationary and furthermore grows faster than the target price level by the inflation

bias.

If social preferences mrrespond to the ifiation target period loss function (2.4), can the price

level target equilibrium still be preferable? That is, would it be preferable to assign a price level

target to the central bank even if social preferences mncern inflation rather than the price level.

In order to answer this question, both equilibria must be evaluated with the inflation-target

social loss function. For the ifiation target quilibriurn, the relevant indirect loss function is

defined in the d=ision problem (2.11) and given by (2.12), with the mefficients $1 and ~z given

by (2,16) and (2.17). The aficient ~0 is derived in the appendix and given in (A. 16).

The value of the inflation-target social loss fiction for the price level target equilibrium,

denoted by VP(lt_l), is defied M

vp(l~_~) = Et-l ~ (7r, - 7r*)’ + A (1, - 1*)’] + Bvp(lt) , (4.1) {[ }

where (3.10) and (2. 14) is substituted for nc and lC. This value function will be quadratic and can be written

(4.2) where the ~fficients ~, R and % remain to be determined.

In order to answer the question above, I thus need to mmpute . (4.3)

This is done in detail in the appendix. However, it is intuitively clear that price level targeting is better than ifiation targeting if society has inflation target preferences (if there is at least moderate employment persistent), since with price level targeting (i) the variability of inflation is less, (ii) any inflation bias is eliminated, and (iii) employment behavior is the same.

This result can be further illuminated by a direct comparison of the decision rules. The optimal rule under commitment with inflation targeting is (2.7). Due to (2.10), it can be written

7rt b“ (1~– pl~_~). (4.4) ‘T”–l–ab”

14 Mation targeting under discretion delivers the decision rule

(4.5)

where d ~ r* and ~ > b*. Price level targeting under discretion delivers the decision rule & 7rt = 7r*- -(1, -it-,). (4.6) l–ah

Clearly, under discretion, price level targeting may deliver a better approximation to the optimal

tie (4.4) than inflation targeting The -fficient ~~ is the same under both kinds oft argeting

(although larger than under commitment). Unemployment behavior is the same. There is no

average itiation bias under prim level targeting, and, with enough persistence, the first difference

of the employment rate, lC—/t. 1, is a better approximation to the unanticipated change in the

employment rati, lt —pit– 1, than jmt the employment rate, lt.

This comparison of decision rul~ abo reveals that price level targeting under discretion does

not deliver the optimal rule for inflation targeting under commitment. Svensson (1996) examines

how modified inflation targets can improve the discretionary equilibrium with persistence in

employment and compares with Rogoff (1985) ‘conservative’ central banks and with Walsh

(1995)-Persson and Tabel.lini (1993) linear inflation contracts.

5 Conclusions

Amrding to m emerging, although not completely unanimous (cf. Dillon ad Fellow (1994)) conventional wisdom, the choice between prim level targeting and itiation targeting involves a trade-off between (1) less low-frequency price level variabilityy and (2) less high-frequency itiation and employment variabihty. This mnventional wisdom arises from the use of exogenous reaction functions or exogenous inflation and price level processes, which may or may not be consistent with objwtives and constraints (including commitment technologies) faced by central banks. In contrast, this paper examines price level and itiation targeting by deriving endogenous decision rules and equilibrium prim level and itiation pr~ses, when central banks have been assignd prim level or ifiation targets and, realistically, act under discretion and f= persistent employment.

In this framework, prim level targeting naturally results in lower low-frequency price level variability than inflation targeting. However, if employment persistent is at le~t moderate, it also radts in lower high-frequency idation variability, munter to conventional wisdom. The

15 reason is that under inflation targeting ifiation depends on the employment rate, whereas under

price level tmgeting it depends on the change in the employment rate; with sficient persistent,

the change in the rate is less variable than the rate itself.

In addition, prim level targeting eliminates the average itiation biw that results under

ifiation targeting when the implicit employment target is lower than the natural employment

rate,

If society’s preferences mrrespond to price level targeting, prim level targeting is clearly

better than ifiation targeting, since the latter results in a non-trend-stationary prim level and,

when there is an inflation bias, in a price level that increasingly deviates from the target price

level. If society’s preferenms instead correspond to tiation targeting, because of the reduced

inflation variability and inflation biaa, it is stall better for society to assign a prim level target to the mntral bank (if employment persistent is at least moderate). This result mn also be understood with reference to the optimal rule under commitment. Under commitment and ifiat ion targeting, itiation depends only on the private information of the central bank, in this w the supply shock. Under discretion and idation targeting, inflation depends on the employment rate; under prim level targeting itiation depends on the change in the employment rate; when employment is persistent, the latter is a better approximation to the supply shock than the former .

The paper has demonstrated the importance of employment persistent for the results, and,

I hope, the benefits of deriving endogenous decision rules for assigned targets rather thm using postulated reaction functiom.

In the model used here price level targeting and i~ation targeting result in the same employ- ment variability. This is because both regimes readt in the same conditional one-period variance of the prim level and the idation rate (although the unconditional variability of one-period in- flation, and the mnditional more-than-one-period variance of the prim level and ifiation rate, are lower under pri~ level targeting), and ordy the unanticipated part of one-period price move- ments affect employment.

However, if nominal wages are downwmdly rigid, anticipated negative inflation () would increase real wages and increase employment. This may increase employment variability; in particular it may redum avemge employment. The eff~t haa &n studid by Lebow, Roberts and Stockton (1992), Crawford and Dupaaqtier (1994), Fillon and Tetlow (1994) and Akerlof,

Dickens and Perry (1996). For given ifiation variability, the effect depends on the average

16 inflation rate, regardless of whether there is price level or inflation targeting. The effect is hence

an argument for a positive inflation target under i~ation targeting and a prim level target that

increases at a steady rate during priw level targeting, since that would reduce the frequency of

deflation. However, the reduced variability of inflation under price level targeting still seems to

be an argument in favor of price level targeting. Productivity growth will in any cue reduce the

effect, For the Unitd States, Lebow Stockton and Wascher (1995) report empirical evidence

that indicate little downward rigidity and very small aggregate output effects of reducing U.S.

ifiation to zero, and in simulations Fillon and Tetlow (1994) also report small output effects.

Akerlof, Dickens and Perry (1996) find larger output and unemployment effects, though. Any

degree of downward nominal rigidity is, however, likely to be endogenous and regime dependent

and hence decrease with less ifiation. 11

Nonnegative nominal interest rates have also been used as an ar~ent for a positive inflation

rate, sins low or negative idation could then result in too high real interest rates, and in

particular prevent monetary policy from being sufficiently expansionary in recessions (Summers

(1991)). But, Lebow (1993) shows that monetary policy can still be expansionary by using other

instruments than interest rates on government bonds and bills, if these interest rates occasionally

fall to zero. In simulations Fuhrer and Madigan (1994) find very small effects on output from

nonnegative nominal interest rate9. The problem will be smaller, if future real interest rates

are generally higher than in the 1960s and the 1970s. For a given average itiat ion rate, the

reduced itiation viability under prim level targeting again seems to speak in favor of price

level targeting.

In any case, to the extent that downwardly rigid nominal wages and nonnegative nominal

interest rates imply a positive average inflation rate, there is no principle difficulty with a price

level target which incre~ at a steady rate, since that does not redum the predictability of the

price level.

The parameters of the Phillips curve (the slope, the degree of persistence, and the variance of

supply shocks) might not be invariant to a shift from ifiation targeting to price level targeting.

It is not obviom, though, whether the parameters are likely to change and if so, in what direction,

-pecially since conditional variances (and average inflation in case the employment target equals

the natural rate) are the same in the two regimes, Clearly a more elaborate analysis with explicit microfoundations of the Phillips curve, is then required. II For ~~tum, ~ ~m~~~y ~mon way to &umvent downward nominalWagerigidityin mY home country is ti add a flmible (and, on averagepositive) non-negativebonus, to a downwardlyrigid wage.

17 Will random walk measurement errors of the price level provide an argument agaimt price

level targeting? No, for if there are such me~urement errors, there will be an unavoidable

random walk mmponent to the ‘true’ pri~ level, but tiation targeting will add another random

walk mmponent, making the variance of the prim level still higher under inflation targeting than

under prim level targeting.

What is the effect of mntrol errors? Suppose there are i,i.d. control errors, qt, on the price

level, with varianm u;. Under itiation targeting, this will add a; to the varianm of iflation.

Under price level targeting, this will be added twim to the variance of inflation, which means

that the degrm of persistent must be somewhat higher (than a half), in order to make the

itiat ion varianm less under price level targeting (unless the variance due to mntrol errors is so

huge as to dominate all other SOW-of variability).

Do social preferenm mrrespond to inflation targeting or price level targeting? What are the

social benefits of redud long-term uncertainty of the prim level? This seems to be an under-

researched area (see Konieczny (1994) and Duguay (1994) for discussion). There are obvious

informational and computational benefits of a stable, or at least predictable, unit of account

for intertemporal decisions and for decisions that occur relatively infrequently. Although these

benefits are obvious, they are difficult to asses quantitatively. Standard mnomic theory is

certainly at a disadvantage assessing such costs, sinm it relies on the assumption on unbounded

mmputational capacity of agents. I believe that we have to some extent become so used to a

randomly incr-ing price level that we have grown blind to the information and computation

costs it imposes, It h= been argued that the analog to length and other physical units is

revealing: Suppose that the meter or the foot were to be randomly redud each year. We cotid

certainly live in such a world; we would only have to keep track of which year meter or foot

things were measured in, and we mtid carry a card in our wallets with the appropriate mnversion

factors, We muld certainly live in such a world; but it wotid no doubt be a mnsiderable struggle.

For some reason, we have come to ~pt such a state of tiairs in the economic sphere.

ReduA long-term uncertainty wotid obviously reduce the unmrtainty associated with long-

term nominal contracts, like long-term nominal bonds. But if the mst of such unmrtainty is

significant, why is it not circumvented by indexation? One possibility is that the information and computational mst of indexation is itself substantial; the fact that citizem seem to shift to foreign currency as a unit of ~unt ody when domestic inflation goes above 20-30 percent per year has been quoted as evidenm that those costs maybe quite substantial (Konieczny (1994)).

18 More work on formal models of the asts of long-term pri~ level uncertainty would be very welcome.

As noted by Konieczny (1994), th~ id- were well put a long time ago:

H there is anything in the world which ought to be stable it is money, the measure of everything which enters the channels of trade. What confusion would there not be in a state where weights md measur~ frequently changed? On what basis and with what ~surance wodd one person deal with another, and which nationa would mme b deal with people who lived in such disorder? (Franpis Le Blanc (1690), hzt~ Htitotique o!e Monnaya de hnce, Paris, quoted by Einaudi (1953, p. 233),)

Appendix

A I-tion targeting

A.1 Commitment to an optimal rule

The fit order conditions with respect to fit and n: restit in

(n, - m“) + Aa(l, - 1“) + pa~”(t~) – Et_~ [Aa(lt – l“) + pau”(~t)] = 0, (Al) where the Lagrange multiplier of (2.2) haa been eliminated.

Taking expectation at t–l of (A. 1) givea

Et-lrc = T*, (A.2) the expected itiation rate equals the socially best inflation rate and is independent of the employment rate. Substitution of (2.1), (2.2), (A.2) and (2.6) into (A. 1) results in the decision rule

7r~= n* —b*et (A,3) with

(A.4)

The employment

1~= pl~-~ +(1 – ab”)c~. (A.5)

In order to tid b*, ~~ hm to be detetined, The coefficients ~i and ~~ an be identifi~ by substituting (A.3) and (A. 5) into (2.5). Together with (2.6) this results in

Almp Ap2 –—<0 and ~j= >0. (A.6) ‘i= 1–PP 1 – pps

19 Using this in (A.4) results in

(A.7)

A.2 Discretion

The first order condition will be

fit – 7r*+ Aa(l~ – f!*)+ pati(lt) = 7rt – n“ + (A + p~z)alt – (Al” – p~l)a = o, (A.8) where I have used (2.12). The marginal loss of increased ifiation expectations have vanished from the first order condition.

Taking expectations of (A.8) gives

Combining (2. 1), (2.2), (A,8) and (A,9) givea a feedbwk rule of the form 6 mt=a— -it, (A.1O) l–ah with

(All)

Unemployment will be given by (2.14),

In order to detetine ~1 ad ~2, I substitute (A.1O) and (2.14) into (2.11). Using (2.12) to identify the coefficient for l?. 1 results in

?2 = (~+ P?2)P2 + (~ + 972)2~2P2. (A.12)

This is a second-degree equation in ~2, which henm has two potential roots, The equation has real roots if and only if the first existenm rendition

(A,13) holds. Only the smaller solution, (2. 17), is relevant (see Lockwood& Philippopoulos (1994) and

Svensson (1996)).

If the second term on the right-hand side of (A.12) were zero, 72 would equal T;, cf. (2.9).

Sinw the term is positive, 72> y;.

Identifimtion of the coefficient for it-l, ~1, results in (2.16). In order to ensure that there is a fite solution to ~1, the second existence condition

pp [1 + (A + P32)a2] <1 (A.14)

20 must hold. The condition has a natural interpretation: The expression on the left hand side of the inequality is the dimunti total increaae in the employment rate in period t of a unit increase in the employment rate in period t – 1, when inflation in period t is held constant.

The total effect mnsists of the direct effect, p, and the indirect effect via redud inflation expect ations, ~ ~, cf. (A.9). If this discounted effect is above unity, the present value of the t eff=t in all future periods will be unbounded.

With (2. 17) one can show that (A.14) is equivalent to

(A.15)

It is shown in Svensson (1996) that for some parameter values (A. 15) is more binding than

(A.13). More prwisely, the complete existence condition is (i) for ~ < p <1 and 0< ~ < ~,

~s~l,(ii)for~~p

A < A2 < Al. If 1“ = O, only (A.13) is relevant.12

Identification of to results in

(A.16)

B Evaluation of pri= level targeting equilibria wit h inflation targeting pref-

erences

Let me start with the first term on the right-hand side of (4.3). Identifiation of the constant

% in (4.1) and (4.2) results, after some algebra, in

(B.1)

From (A. 16) we have

(B.2)

Thus

(B.3)

12 The conditiom (A.14) and (A. 15) do not appear in the analysiaof kckwood and Philippopoulos (1994), since they mume that 1“ = O. If a in (2.1) equale unity (as in bckwood and Philipppouloe (lU) and in Lockwood, Miller and Zhang (1995)), the ~tenm mnditione appear rather restrictive. Lf~ = 0.95 and p = 0.4 (0.8), we have ~ = –1.25 (0.4), ao (A.15) appli=. Then A2 = 0.98 (0.06), ~mtively. U a insti equala0.2, the mrresponding AZvalu~ are 25 times larger, that is, 24.5 (1.58). The co-riding valua for Al are 1.18 (0.M) for a = 1, and 29.6 (1,58) for a = 0.2.

21 The first term on the right-hand side is negative and obviously arises b=use the price level target

equilibria has no average inflation bias. The second term depends on the difference between

the -fficients % and ~z, that is, the convexity of the indirect loss function. Identification of

Win (4.1) and (4.2) gives

~= ~P2+(+,)2(1-P)’ (B.4) 1–PP2 “ In order to facilitate comparison, by (All) and (A. 12), ~z can be written as13

(B.5)

Henm,

~ ~’ (*)2 [(1-P)2-P’1 (*)2(1-2P) = (B.6) l-pp’ = l-pp’ ‘

The difference between ~ and ~z is negative when p > ~, since the idation rate is less sensitive to lagged employment under prim level targeting if P > ~. A given level of 1~.1 in period t – 1 will give rise to a squared idation term in period t equal to (&)’(1 -P)2J:-I ~der aPrice level target and equal to ~ 22p lt_l under an ifiation target (the present value of a future () sequence of such terms requires diwunting by ~p’).

Finally, let me look at the sand term in (4. 3), corresponding to the linear term in the value functions. Identifying the linear term in (4,1) and (4.2) gives

<=_*. (B.7) ~–PP In order to facilitate mmparison, I use (A, 11), (All) and (2.16) with some algebra to rewrite

~1 in terms of the average tiation bi~,L4

(B.8)

Hence

(B.9)

13Noh that by (All) (A+ fi2)a = ~. Substitute this ink the and termon theright-handsideof (A. 12). 14Writi (2.16) as . N*p+AQl*c ~l=-l–pp-pac’

and use (All).

22 This difference mises since an increase in /t. 1 reduces the lees function more under inflation targeting the resulting reduction in nt is more beneficial sinm the average inflation bias is positive under ifiation targeting.

The unconditional mean of (4.3) is

E [VP(lt_l) – V(lt-1)] = ~ – ?O + ;(% – ~2)Var [1~-1]. (B.1O)

This is strictly negative for p > ~.

C Simple inflation targeting and prim level targeting processes

Supposeinfition ta~etzng results in the AR(1) pr~s for idation

~t = hrt- .1 +nt, (Cl) where Ihl < 1 and qt is i.i.d. with E[qt] = O and Var[qt] = S*. The unmnditional varianm of inflation under inflation targeting, denoted Var[nt]n, fti

(C.2)

The price level h= a unit root,

Pt =Pt-1 +~t, (C.3) and its unconditional variance is unboundd.

Suppose ptice level ta~eting results in the AR(1) process for the price level

Pt = km-l + qt, where IkI <1. The unmnditional variance of the price level, denoted Var~t]P , is then

The corresponding inflation process is

7rt=pt-pt-1= -(1 - k)pt-1 + q,.

The unmnditional varianm of tiation under prim level targeting, Var[rt]P, is

2s2 Var [nt]p = (1 – k)2Var ~t]p + S2 = ~. (C.4)

23 The differenm between the unmnditional variance of idation under price level targeting and ifiation targeting is

2 1 l–2h2–k ~z Var [7r~]P– Var [~t]m= ——~ + ~ — ‘2= (~_ hz)(l + k) “ ( l–h2 ) Hence, Var [7rt]p< Var [~tl. ifand onlyif k>l–2h2. (C.5)

We see that if h = k, we have Var [zt]P < Var [rt]T if and only if h = k > ~.

Fischer (1994, Figure 2.4 and Footnote 45) mmpar~ (C.2) and (C.4) with h = Oand k = 0.5, for which case k <1 – 2h2 and Var[rt]P = $s2 >Var[rt]r = S2; the itiation variance is higher under price level targeting.

Duguay (1994) examines the processes (Cl) and (C.3) for different values of h and k. Typical values used are h = 0.5 and 0.7 (tiation targeting such that 75% oft he adjustment of inflation towards the target is achievd in 2 and 4 perid (years), respectively), k = 0.7 (price level targeting where 75% of the adjustment of the prim level towar~ the target is achieved in 4 periods (years)), and s2 —– 1 (when ~ and p are meas~ed in YO/year and ~0, respectively) ‘hat ‘s! scaled by 100).15 Let me use these values and mmpute the unmnditional variance of inflation.

For th= values, k > 1 – 2h2, the variance is less under price level targeting, and we get

Var[nt]r = 1.33 and 1.95, respectively, and Var[~t]P = 1.18. Now the variance of ifiation is lower under price level targeting.

Duguay (1994) d- not report this unmnditional standard deviation of one-period inflation; instead he reports the conditional standard deviation of the price level and the average inflation rate, fl~ and vart~ = - T-t ~for different time horizons T – t. Tables Al and A2 P summarize some results for the pr-ses (Cl) and (C.3). What univariate processes for idation and the price level do tiation targeting and price level targeting under discretion result in? Under inflation targeting (2.13) implies lt= +(7rt -

~). Using this in (2.14) results in

nt = (1 – p)a + p7rt-1 + &t. (C.6)

Thus, disregarding the mnstant, itiation targeting correspond to the prmss (Cl) with h=p.

Under price level targeting (3.8) implies lt = ~ (pt – at). Using this in (2.14) gives

(C.7) where fit = pt – at. Thus, the pr~s for fi corresponds to the process (C. 3) with k = p. The corresponding ifiation process will be

m,= 7r*-(1 –p)(pt-~ -a,_~) +&t. (C.8)

Thus, for h = k = p > ~ we get the result that Var [rt]P < Var [mt]T,

~ble Al. Inflation targeting (1) 7r, = h7r,-, +q!

(2) fi= = h=-~7rt + ~:=t+l h~-’q7

(3) P= = Pt + E;=t+l ~T (4) v~t~= = 1 – h2tT-tJ ~ ( ) 1-;::-’) ~z] ~ls;) (5) Var,~ = [(T-t ) –2~h+ (6) Var [mt]r = ~

(7) v= bt]. = m

Table A2. Price level targeting (1) pt = kpt-1 + ~t (2) 7r, = –(1 – k)pt-l +qt

(3) P= = k=-tpt + Z;=t+l k=-’q. (4) ~= = -(1 - k)~_l +~*

(5) Vart~ = 1- k2(T-tJ ~ ( ) (6) Vart~t+l = S2

(7) var~~= = [(1 -~)’ (1 -k2(T-’-”) +1 -k’] + (~22) (7) VW kt]p = *

(9) Var [fit], = ~

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Walsh, Carl (1995), “Optimal bntracts for Independent ~ntral Bankers,” Ametimn Em- nomic Review 85, 150-167.

28 To order any of thesepapers,seeinstructionsat theend of thelist. To subscribeto all NBER Working Papers or thepapersin a single area, see instructions inside the back cover. A complete list of NBER Working Papers and Reprints can be accessed on the Internet by using our gopher at nber.harvard.edu or our World Wide Web site at http :Ilnber.harvard. edul.

Number ~ ~

5668 FrankLichtenberg International R&D Spillovers: A 7/96 Bruno van Pottelsberghe de Re-Examination la Potterie

5669 John Cawley An Empirical Examination of Information 7/96 Tomas Philipson Barriers to Trade in Insurance

5670 Fukunari Kimura Application of Nationality-Adjusted 7196 Robert E. Baldwin Net Sales and Value Added Framework: The Case of Japan

5671 OwenLament Earnings and Expected Returns 7/96

5672 Edward P. Lazear Performance Pay and Productivity 7/96

5673 Pinelopi Koujianou Goldberg The Effects of the Corporate Average 7196 Fuel Efficiency Standards

5674 Michael Kremer Elephants 7/96 Charles Morcom

5675 Robert E. Cumby Forecasting Exchange Rates and Relative 7/96 Prices With the Hamburger Standard: Is What You Want What You Get With McParity?

5676 Matthew B. Canzoneri Relative Labor Productivity and the Real 7/96 Robert E. Cumby Exchange Rate in the Long Run: Evidence Behzad Diba for a Panel of OECD Countries

5677 James M. Poterba Demographic Structure and the Political 7/96 Economy of Public Education

5678 Fernando Alvarez Money and Exchange Rates in the 7/96 Andrew Atkeson Grossman-Weiss-Rotemberg Model

5679 Lawrence F. Katz Wage Subsidies for the Disadvantaged 7196

5680 Kala Krishna Implementing Results-Oriented Trade 7196 JohnMorgan Policies: The Case of the US-Japanese Auto Parts Dispute

5681 BarryEichengreen Contagious Currency Crises 7/96 AndrewK. Rose CharlesWyplosz

5682 B. DouglasBernheim Optimal Money Burning: Theory and 7/96 Lee Redding Application to Corporate Dividend Policy To order any of these papers, see instructions at the end of the list. To subscribe to all NBER Working Papers or the papers in a single area, see instructions inside the back cover. A complete list of NBER Working Papers and Reprints can be accessed on the Internet by using our gopher at nber.harvard.edu or our World Wide Web site at http:llnber.ha rvard.edul,

Number Author(s) ~ ~

5683 Kevin A. Hassett Tax Policy and Investment 7/96 R. Glenn Hubbard

5684 Michael Woodford Control of the Public Debt: A Requirement 7/96 for Price Stability?

5685 John Bound Demand Shifts, Population Adjustments, ‘7196 Harry J. Holzer and Labor Market Outcomes during the 1980s

5686 R. Glenn Hubbard Assessing the Effectiveness of Saving 7/96 Jonathan S. Skinner Incentives

5687 David Card Deregulation and Labor Earnings in the 7/96 Airline Industry

5688 Christopher J. Ruhm The Economic Consequences of Parental 7/96 Leave Mandates: Lessons From Europe

5689 Jean O. Lanjouw Preliminary Injunctive Relief: Theory and 7/96 Josh Lerner Evidence from Patent Litigation

5690 Jeff Dominitz Perceptions of Economic Insecurity: Evidence 7[96 Charles F. Manski from the Survey of Economic Expectations

5691 Russell Cooper Dynamic Complementarities: A Quantitative 7196 Alok Johri Analysis

5692 Christina D. Romer Federal Reserve Private Information and the 7/96 David H. Romer Behavior of Interest Rates

5693 Donald R, Davis Trade Liberalization and Income Distribution 8/96

5694 Alberto Alesina International Conflict, Defense Spending and 8/96 Enrico Splaore the Size of Countries

5695 Barbara J. Spencer Quota Licenses for Imported Capital 8/96 Equipment: Could Bureaucrats Ever Do Better Than the Market?

5696 James R, Markusen A Unified Treatment of Horizontal Direct 8/96 Anthony J. Venables Investment, Vertical Direct Investment, and Denise Eby Konan the Pattern of Trade in and Services Kevin H. Zhang

5697 Kiminori Matsuyarna Why Are There Rich and Poor Countries?: 8/96 Symmetry-Breaking in the World Economy To order any of these papers, see instructions at the end of the list. To subscribe to all NBER Working Papers or the papers in a single area, see instructions inside the back cover. A complete list of NBER Working Papers and Reprints can be accessed on the Internet by using our gopher at nber.harvard.edu or our World Wide Web site at http: //nber.harvard. edul.

Number Author(s) ~

5698 Robert J. Barro Determinants of Economic Growth: A 8/96 Cross-Country Empirical Study

5699 Anna J. Schwartz From Obscurity to Notoriety: A Biography 8/96 of the Exchange Stabilization Fund

5700 Jeffrey A. Frankel The Endogeneity of the Optimum 8/96 Andrew K. Rose Currency Area Criteria

5701 David Card Do Financial Incentives Encourage Welfare 8/96 Philip K. Robins Recipients to Work? Evidence from a Randomized Evaluation of the Self-Sufficiency Project

5702 Kym Anderson Social Policy Dimensions of Economic 8/96 Integration: Environmental and Labour Standards

5703 Lawrence J. Christian Chaos, Sunspots, and Automatic 8/96 Sharon G. Harrison Stabilizers

5704 Herschel I. Grossman Inequality, Predation, and Welfare 8/96 Minseong Kim

5705 Robert Gibbons Incentives and Careers in Organizations 8/96

5706 Donald R. Davis Does Economic Geography Matter for 8/96 David E. Weinstein International Specialization?

5707 Olivia Mitchell Construction of the Earnings and Benefits 8/96 Jan Olson File (EBF) for Use With the Health and Thomas Steinmeier Retirement Survey

5708 David Card School Resources and Student Outcomes: 8/96 Alan Krueger An Overview of the Literature and New Evidence from North and South Carolina

5709 Menzie Chinn Real Exchange Rate Levels, Productivity 8/96 Louis Johnston and Demand Shocks: Evidence from a Panel of 14 Countries

5710 Michael D. Bordo Why Clashes Between Internal and External 8/96 Anna J. Schwartz Stability Goals End in Currency Crises, 1797-1994

5711 Arrnen Hovakimian Risk-Shifting by Federally Insured 8/96 Edward J. Kane Commercial Banks To order any of these papers, see instructions at the end of the list. To subscribe to all NBER Working Papers or the papers in a single area, see instructions inside the back cover. A complete list of NBER Working Papers and Reprints can be accessed on the Internet by using our gopher at nber.harvard.edu or our World Wide Web site at http ://nber.harvard. edul.

Number Author(s\ ~ ~

5712 Adam B. Jaffe Flows of Knowledge from Universities and 8/96 Manuel Trajtenberg Federal Labs: Modeling the Flow of Patent Citations Over Time and Across Institutional and Geographic Boundaries

5713 Michael Grossman The Demand for Cocaine by Young Adults: 8196 Frank J. Chaloupka A Rational Addiction Approach Charles C. Brown

5714 Jeffrey A. Frankel Country Fund Discounts, Asymmetric 8196 Sergio L. Schmukler Information and the Mexican Crisis of 1994: Did Local Residents Turn Pessimistic Before International Investors?

5715 Sofronis Clerides Is “Learning-by-Exporting” Important? 8/96 Saul Lath Micro-dynamic Evidence from Colombia, James Tybout Mexico and Morocco

5716 Jennifer Hunt The Response of Wages and Actual Hours 8/96 Worked to the Reduction of Standard Hours in Germany

5717 Fiona Scott Morton The Strategic Response by Pharmaceutical 8/96 Firms to the Medicaid Most-Favored- Customer Rules

5718 Michael Kremer Wage Inequality and Segregation by Skill 8/96 Eric Maskin

5719 Lars E. O. Svensson Price Level Tmgeting vs. Inflation 8/96 Targeting: A Free Lunch?

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