Linear-quadratic approximation, external habit and targeting rules

Paul Levine (p.levine@surrey.ac.uk), Joseph Pearlman and Richard Pierse

No 759, Working Paper Series from European Central Bank

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

Keywords: dynamic stochastic general equilibrium models; Linear-quadratic approximation; utility-based loss function. (search for similar items in EconPapers)
Date: 2007-06
References: View complete reference list from CitEc
Citations: View citations in EconPapers (20)

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Journal Article: Linear-quadratic approximation, external habit and targeting rules (2008)
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