In this paper, we examine the areas of indeterminacy in a flexible price RBC model with shopping time role for money and a central bank that uses an interest rate rule to target inflation and/or the price level. We present analytical results showing that, although inflation targeting often results in real indeterminacy, a price level target generally delivers a unique equilibrium for a relevant range of policy parameters.Monetary policy ; Equilibrium (Economics)

Robert Dittmar

William T. Gavin

English

Research Papers in Economics

 
 
 
 
 
 
 
 
 
 
WORKING PAPER SERIES 
 
 
 
Inflation-Targeting, Price-Path Targeting and Indeterminacy 
 
 
 
Robert D. Dittmar  
and 
William T. Gavin 
 
 
 
Working Paper 2004-007B 
http://research.stlouisfed.org/wp/2004/2004-007.pdf 
 
 
 
March 2004 
Revised December 2004 
 
 
 
FEDERAL RESERVE BANK OF ST. LOUIS 
Research Division 
411 Locust Street 
St. Louis, MO 63102 
______________________________________________________________________________________ 
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Federal Reserve Bank of St. Louis Working Papers are preliminary materials circulated to stimulate 
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cleared with the author or authors. 
Photo courtesy of The Gateway Arch, St. Louis, MO.   www.gatewayarch.com Inflation-Targeting, Price-Path Targeting and Indeterminacy 
By Robert D. Dittmar and William T. Gavin 
Abstract 
In this paper, we examine the areas of indeterminacy in a flexible price RBC model with 
shopping time role for money and a central bank that uses an interest rate rule to target 
inflation and/or the price level.  We present analytical results showing that, although 
inflation targeting often results in real indeterminacy, a price level target generally 
delivers a unique equilibrium for a relevant range of policy parameters.   
 
Keywords:  Inflation targeting, price-path targeting, indeterminacy 
 
JEL Classification:  C62, E52 
 
Original Date: September 26, 2003, Revised December 21, 2004 
 
 
Robert D. Dittmar       William T. Gavin 
Mathematician        Vice President and Economist 
Research Department      Research Department 
Federal Reserve Bank of St. Louis    Federal Reserve Bank of St. Louis 
P.O. Box 442        P.O. Box 442 
St. Louis, MO 63166-0442      St. Louis, MO 63166-0442 
dittmar@stls.frb.org     gavin@stls.frb.org
 
 
 
 
 
The views expressed here are those of the individual authors and do not necessarily 
reflect official positions of the Federal Reserve Bank of St. Louis or of the Federal 
Reserve System.  We thank Jim Bullard and Chuck Carlstrom for helpful comments on 
an earlier draft.  
1.  Introduction 
Economists working in theoretical models have long understood that finding 
solutions to models with interest rate rules and forward-looking agents can be 
problematic because a relevant range of parameter values often leads to multiple 
solutions (or, equivalently, areas of indeterminacy).  Sargent and Wallace (1975) showed 
that interest rates rules could lead to price level indeterminacy in models with forward-
looking agents.  McCallum (1981, 1986) showed that modifying the rule to include the 
lagged money supply was one of many possible ways to eliminate indeterminacy in the 
price level.  He has argued that many cases of indeterminacy are the result of 
inappropriate specification choices. 
However, the issue about indeterminacy in monetary models is still interesting 
because it turns out that the conditions for real determinacy in dynamic general 
equilibrium models depend critically on model specifications of policy rules that are 
thought to correspond to features in modern economies.      
Benhabib and Farmer (1999) summarize literature in which researchers have used 
models with indeterminacy to explain sticky prices and real effects of monetary policy.  
For the policy economist, the issue is whether inappropriately designed policy institutions 
increase the probability of asset pricing bubbles and other self-fulfilling prophecies that 
can be generated in models with multiple equilibria.   If so, then policymakers want to 
design institutions that eliminate this potential source of instability.
1   
                                                 
1 For a discussion of indeterminacy in the context of policy design see McCallum (2003), Woodford 
(2003a,b) and Benhabib, Schmitt-Grohe and Uribe (2003). 
  1  Giannoni (2000) investigates the optimality of alternative interest rate rules in a 
New Keynesian economy.  Using a sticky-price model, he shows that while 
indeterminacy is present for some range of parameters in the inflation targeting regimes, 
they disappear when the central bank targets a price path.  In this paper we show that a 
similar result also holds in a flexible-price model.   
 
2.  The Economic Model 
  The model we use here is a slighted modified version of the monetary business 
cycle model developed in Dittmar, Gavin and Kydland (2004).  In each period, infinitely- 
lived consumers decide how to allocate time between work, leisure, and transaction-
related activities such as trips to the bank, shopping, and so on.  Larger money balances 
carried in from the previous period make the shopping activity less time consuming, 
leaving more time for work and leisure. New money enters the economy as a government 
transfer but does not reduce shopping time until the next period.
2  The government sets a 
target for the nominal interest rate on bonds and transfers whatever amount of money is 
necessary to achieve it.   
  Many identical households inhabit the model economy.  Each household 
maximizes 
0
0
(,) ,
t
tt
t
Eu c β
∞
= ∑                                                                    (1) 
where 0 < β < 1 is a discount factor, ct is consumption expenditure, and ℓt is leisure time.  
The current-period utility function is linear in leisure but otherwise general.   
                                                 
2 Note that this is timing convention used in Kydland (1989).   
  2   The household’s stock of capital, k, is governed by the law of motion, 
1 (1 ) , t kk t t i δ + = −+                                                          (2) 
where 0 < δ  < 1,  δ  is the depreciation rate, and it is investment.   
Household time spent on transactions-related activities in period t is given by  
0 ,
t
t
m
P
ω
ω
⎛⎞
−Ω⎜⎟
⎝⎠
                                                      (3) 
mt is the nominal stock of money, and Pt is the price of physical goods relative to that of 
money. The parameter, Ω, represents the level of shopping time technology.  By 
restricting Ω  and ω  to have the same sign and ω  < 1, the amount of time saved increases 
as a function of real money holdings, but at a decreasing rate.  Note that this shopping 
time function differs from Dittmar, Gavin and Kydland (2003) because it does not 
include consumption expenditures.   With leisure linear in utility, this assumption allows 
us to reduce our dynamic system to only two equations. 
Leisure in period t is  
0 ,
t
tt
t
m
Tn
P
ω
ω
⎛⎞
=−− + Ω ⎜⎟
⎝⎠
                                                    (4) 
where T is the total time available and nt is time spent in market production. 
 Aggregate  output,  Yt, is produced using labor and capital inputs: 
  
1 , tt t t t YCIz N K
θ θ − =+ =                                                       (5) 
where It is the total of investment expenditures and z is the level of technology.  We 
assume a Cobb-Douglas production function with labor share θ : 0 < θ <1. 
The nominal budget constraint for the typical individual is 
  31
11 (1 ) ,
t tt tt t t t t t t tt t t Pc Pk b m Pzn k P k Rb m v
θθ δ
−
++ +++= +− ++ +                 (6) 
where bt+1 are nominal bonds carried into period t, and vt is a nominal lump-sum transfer 
from the government.   t R  is the gross nominal interest rate earned on bonds which are 
assumed to be in zero net supply in equilibrium.  The government transfers money 
balances directly to households according to its policy rule.  It produces money and 
conducts policy at zero cost and does not have any expenditures or revenues. 
   A law of motion analogous to that for individual capital describes the aggregate 
quantity of capital.  The distinction between individual and aggregate variables is 
represented here by lowercase and uppercase letters, respectively.  Competitive factor 
markets will imply that in equilibrium each factor receives its marginal product.  
The central bank manipulates the monetary transfer to implement an interest rate 
rule of the type: 
  11 1 2 1 ln ln (ln ln ), tt t t R PP κν ν ++ + =+ + −P                                        (7) 
where ln 1 t R +  is the period t+1 nominal interest rate target chosen by the central bank.  
The interest rate is set as a function of the price level and the inflation rate.    
The Dynamic System.  The agent’s choice of any four variables–say leisure, labor, 
capital and bonds–will determine the others via his budget and time constraints.  Here, we 
assume that utility is linear in leisure: 
() t
u
l
ε
∂
≡
∂
i                                                                    (8) 
where ε is an arbitrary constant. We define the labor-capital ratio as  / tt t x nk =  and 
compute the first order conditions for labor, capital, and bonds in terms of this ratio.   The 
first order condition for labor is given as: 
  4() 1 , t
t
u
cz x
θ
ε
θ
−
∂
≡
∂
i                                                        (9) 
which equates the marginal utility of consumption to the marginal utility of labor relative 
to the marginal product of labor.  The first order condition for capital is given as: 
() ( ) ()
1
11 11
tt
tt t t
uu
Ez x
cc
θ ββ θδ
+
++
∂∂ ⎧⎫ ⎡⎤ +− + − ⎨⎬ ⎣⎦ ∂∂ ⎩⎭
ii 0 , =                        (10) 
which equates the intertemporal rate of substitution of consumption in utility to the 
intertemporal rate of transformation of output in production.  The first order condition for 
bonds is given as: 
() () 1
1
11
, tt t t
tt
u
ER
Pc P c
β +
+
1
u
+
⎡ ⎤ ∂∂
= ⎢ ⎥ ∂∂ ⎣ ⎦
ii                                       (11) 
which relates the nominal interest rate to the inflation rate and the intertemporal rate of 
substitution in consumption.   
Substituting the first order condition for labor (9) into the first order conditions 
for capital (10) and bonds (11), we get: 
() { }
11
11 11 tt t t xE x zx
θθθ βθ
−−
++ , δ ⎡ ⎤ =− + − ⎣ ⎦ and                                       (12) 
1 1
1
1
1
.
t
tt t
tt
R
xEx
PP
θ β
− +
+
+
⎛⎞
= ⎜
⎝⎠
1 θ −
⎟                                                      (13) 
In the steady state,  () 1 1/ 1 1 t zx
θ β θδ + =− + −  and  1/ . R β =   After defining  ln tt x x =   and 
, we log linearize (12) and (13) to get two first order difference equations in the 
log of the price level and the log of the labor-capital ratio: 
ln t P =  
t P
1
1( 1 )
,
1
tt t x Ex
βθ δ
θ
+
−− ⎛⎞ ∆= ∆ ⎜⎟ − ⎝⎠
   and                                        (14) 
  5() ( ) 11 1 1 tt t t t Px E R P x θ ++ + 1 , t θ ⎡ ⎤ −∆ + − ∆ = ∆ −∆ + − ∆ ⎣ ⎦
                                    (15) 
We log-linearize the interest-rate rule (7) to get: 
( ) 11 2 1 2 . tt t t t ER EP P νν ν ++ ∆=+ ∆− ∆                                                  (16 ) 
Substituting (16) into (15), we get: 
() ( ) ( ) 12 12 1 11 1 tt t t t Px E P Px θν νν θ + ⎡⎤ ∆+− ∆= + −∆ −∆+− ∆ ⎣⎦
        , t +                       (17) 
Equations (14) and (17) form a two-equation system with two roots: 
 
1
1
tt t
tt t
E xx
AB
E PP
+
+
∆ ∆ ⎡ ⎤⎡
=
⎤
⎢ ⎥⎢ ⎥ ∆ ∆ ⎣ ⎦⎣
  
   ⎦
−+ − ⎣⎦ 2
10
11
B
θ
θν
−
, 
Where  
  and  ()
12
11 0
11
A
βθ δ
θν ν
⎡− − ⎤
= ⎢⎥
⎡ ⎤
= ⎢ ⎥ − − ⎣ ⎦
. 
For a unique solution to this system we need one eigenvalue inside the unit circle and the 
other outside.  The eigenvalues of   are given by 
1 AB
− ( ) [ ] 1/ 1 ( 1 ) θ βδ θ −− −  and 
() ( 21 1/ 1 ) 2 ν νν −− − .  The first is between zero and one by our model assumptions and 
the second is greater than unity for the combination of values shown in the shaded 
regions in figure 1.  If there is no weight on inflation, then the model is determined for 0 
< ν1 < 2.  The general conditions for determinacy are: 
 
1
12 01
2
,
ν
νν ⎛⎞ >→ − ∞ < < − ⎜⎟
⎝⎠
 and  
1
12 01
2
ν
νν ⎛⎞ . < →−<< ∞ ⎜⎟
⎝⎠
 
  6  Of special interest is the case of a pure inflation target, i.e.  1 0 v = .  In this case, we 
can show that there is indeterminacy everywhere.  To see this we first note that if  1 0 v = , 
then we can rewrite equation (17) as follows: 
() ( ) ( ) 21 11 ( ) 1 tt t tt 1 . t x EP P E x θν θ + + −∆ = − ∆ − ∆+− ∆                                  (18) 
If we let  11 / tt PP t π ++ =  be the inflation rate at time t+1 and  1 ln t 1 t π π + + =   , then by 
definition we have  11 tt t t t E EP P π ++ ∆= ∆ − ∆       .  Therefore equation (18) above can be written 
as a difference equation in  t x ∆  ,  1 tt E π + ∆   , and  1 tt E x + ∆  , namely: 
() ( ) ( ) 21 11 1 tt t t 1 . t x EE θν πθ x + + −∆ = − ∆ + − ∆                                   (19) 
  Combining equations (19) and (14) as above again gives a two variable system of 
difference equations that can be written as: 
1
1
,
tt t
tt t
E xx
AB
E π π
+
+
∆∆ ⎡ ⎤⎡ ⎤
= ⎢ ⎥⎢ ⎥ ∆∆ ⎣ ⎦⎣ ⎦
  
  
 
where 
( )
1
11 0
11
A
βθ δ
θν
⎡− − ⎤
= ⎢⎥ −− ⎣⎦
 and 
10
.
10
B
θ
θ
− ⎡ ⎤
= ⎢ ⎥ − ⎣ ⎦
 
For a unique solution, we again would need one eigenvalue of   to be inside the unit 
circle and one eigenvalue outside the unit circle.  Here, however, one eigenvalue of 
is given by ()
1 AB
−
1 AB
− [ ] 1/ 1 ( 1 ) θ βδ θ −− −  which is positive and strictly less than 1 by our 
model assumptions while the other eigenvalue is exactly 0.  The model is therefore 
indeterminate with a pure inflation targeting rule for any value of 1 ν .
3
                                                 
3 Note that this result appears to be at odds with Woodford (2003, proposition 2.6), but it is not.  He has a 
cashless economy with determinacy conditions that are the same as a model in which money balances at the 
  7 
3. Concluding Remarks 
We find that the indeterminacy that can arise with inflation targeting disappears 
when the inflation target is replaced with a path for the price level.  In the real world 
central banks do not set paths for the price level, but they do tend to target inflation 
averaged over multiple periods.  Countries often adopted inflation targeting in order to 
eliminate high and variable inflation.  As inflation fell, these countries seem to have 
settled on a single target that is repeated year after year.  For example, the Bank of 
Canada has had the same inflation targeting range, one to three percent, since 1995 and 
the Bank of England has had a single inflation target, 2.5 percent, since 1998. Our model 
suggests that doing so may be a good idea if the implementation of such a regime 
approximates a target path for the price level.   
                                                                                                                                                 
end of the period enter utility.   In our model, only money balances brought into the period enter the 
shopping time function (and current period utility).  See Carlstrom and Fuerst (2001a) for a detailed 
analysis of how this timing assumption affects the determinacy conditions.  Carlstom and Fuerst (2001b) 
present results for contemporaneous policy rules. 
  8References 
Benhabib, J., and R.E.A. Farmer, 1999, Indeterminacy and sunspots in macroeconomics, 
in:  J.B. Taylor and M. Woodford, eds. Handbook of Macroeconomics, Vol 1, 
Elsevier Science B.V. 1999, 387-448. 
 
Benhabib, J., S. Schmitt-Grohé, and M. Uribe.  “Backward-Looking Interest-Rate Rules, 
Interest-Rate Smoothing, and Macroeconomic Instability,” mimeo, New York 
University, June 2003. 
 
Carlstrom, C.T., and T.S. Fuerst.  "Timing and Real Indeterminacy in Monetary Models," 
Journal of Monetary Economics 47 (2001a), 285-298. 
 
________, and ________.  "Real Indeterminacy in Monetary Models with Nominal 
Interest Rate Distortions," Review of Economic Dynamics 4 (2001b), 767-789. 
 
Dittmar, R.D., W.T. Gavin, and F.E. Kydland. "Inflation Persistence and Flexible Prices,"  
Federal Reserve Bank of St. Louis Working Paper 2001-010E, March 2004, 
forthcoming in the International Economic Review. 
 
Giannoni, M.P.  “Optimal Interest-Rate Rules in a Forward-Looking Model, and Inflation 
Stabilization versus Price-Level Stabilization."  mimeo, Columbia University, 
October 2000. 
 
Kydland, F.E.  “Monetary Policy in Models with Capital,” in Dynamic Policy Games, 
van der Ploeg, F. and A. J. de Zeeuw eds. Elsevier Science Publishers B. V. 
(North-Holland), 1989. 
 
McCallum, B.T. “Multiple-Solution Indeterminacies in Monetary Policy Analysis,” 
Journal of Monetary Economics 50 (2003), 1153-75. 
 
________. “Some Issues Concerning Interest Rate Pegging, Price Level Determinacy and 
the Real Bills Doctrine,” Journal of Monetary Economics  17 (January 1986), 
135-160.  
 
________. “Price Level Determinacy with an Interest Rate Policy Rule and Rational 
Expectations,” Journal of Monetary Economics  8 (November 1981), 319-329.  
 
Sargent, T.J., and N. Wallace.  “Rational Expectations, the Optimal Monetary Instrument 
and the Optimal Monetary Policy Rule,” Journal of Political Economy 83 (1975), 
241-254. 
 
Woodford, M.,  Interest and Prices, Princeton University Press: Princeton, 2003a. 
 
________, “Comment on: Multiple-Solution Indeterminacies in Monetary Policy 
Analysis,” Journal of Monetary Economics 50 (2003b), 1177-88. 
  9 
-1
-0.5
0
0.5
1
1.5
2
- 2 - 10123
Figure 1:  Determinacy Conditions for Policy Parameters
Weight on the price level, ν1
W
e
i
g
h
t
 
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n
 
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h
e
 
i
n
f
l
a
t
i
o
n
 
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a
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  10

Inflation-targeting, price-path targeting and indeterminacy

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Inflation-targeting, price-path targeting and indeterminacy

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