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Linear-quadratic approximation, external habit and targeting rules

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  • Levine, Paul
  • Pearlman, Joseph G.
  • Pierse, Richard

Abstract

We examine the linear-quadratic (LQ) approximation of non-linear stochastic dynamic optimization problems in macroeconomics, in particular for monetary policy. We make four main contributions: first, we draw attention to a general Hamiltonian framework for LQ approximation due to Magill (1977). We show that the procedure for the 'large distortions' case of Benigno and Woodford (2003, 2005) is equivalent to the Hamiltonian approach, but the latter is far easier to implement. Second, we apply the Hamiltonian approach to a Dynamic Stochastic General Equilibrium model with external habit in consumption. Third, we introduce the concept of target-implementability which fits in with the general notion of targeting rules proposed by Svensson (2003, 2005). We derive sufficient conditions for the LQ approximation to have this property in the vicinity of a zero-inflation steady state. Finally, we extend the Hamiltonian approach to a non-cooperative equilibrium in a two-country model. JEL Classification: E52, E37, E58

Suggested Citation

  • Levine, Paul & Pearlman, Joseph G. & Pierse, Richard, 2007. "Linear-quadratic approximation, external habit and targeting rules," Working Paper Series 759, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:2007759
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    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation: Models and Applications
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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