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On Signal Extra tion and Non-Certainty-Equivalen e in

Optimal Monetary Poli y Rules

Eri T. Swanson
Board of Governors of the Federal Reserve System
eswansonfrb.gov

Abstra t
A standard result in the literature on monetary poli y rules is that of er-
tainty equivalen e: given the expe ted values of all the state variables of the
e onomy, poli y should be set in a way that is independent of all higher mo-
ments of those variables. Some ex eptions to this rule have been pointed out
by Smets (1998), who restri ts poli y to respond to only a limited subset of
state variables, and by Orphanides (1998), who restri ts poli y to respond to
estimates of the state variables that are biased. In ontrast, this paper stud-
ies unrestri ted, fully optimal poli y rules with optimal estimation of state
variables. The rules in this framework exhibit ertainty equivalen e with re-
spe t to estimates of an unobserved, possibly ompli ated, state of the e on-
omy X , but are not ertainty-equivalent when 1) a signal-extra tion problem
is involved in the estimation of X , and 2) the optimal rule is expressed as
a redu ed form that ombines poli ymakers' estimation and poli y-setting
stages. In general, I show that it is optimal for poli ymakers to attenuate
their rea tion oeÆ ient on a variable about whi h un ertainty has in reased,
while responding more aggressively to all other variables, about whi h un-
ertainty hasn't hanged.

JEL Classi ation: E52
Version 0.5.1
May 30, 2000

I thank Athanasios Orphanides, Glenn Rudebus h, Brian Sa k, David Small, Volker
Wieland, and parti ipants at the San Fran is o Fed/Stanford SIEPR Conferen e for
helpful dis ussions, omments, and suggestions. The views expressed in this paper,
and all errors and omissions, should be regarded as those solely of the author, and are
not ne essarily those of the individuals listed above, the Federal Reserve System, or
its Board of Governors.
1
1. Introdu tion

In reased un ertainty about the urrent growth rate of produ tivity, potential output,
and the natural rate of unemployment has led to questions about how monetary poli y
should be altered in the fa e of this un ertainty. The question is extremely important
from a pra ti al point of view (What should the Federal Reserve do today?), as well as
being of parti ular theoreti al interest (What are the various types of un ertainty fa ed
by poli ymakers, and what e e ts should ea h of these have on optimal poli y?)
A natural pla e to begin the investigation of these diÆ ult questions is within the
framework of monetary poli y rules, su h as those put forward by Taylor (1993). The
advantage of these rules is that they are expli it, well-de ned, and simple fun tions of
variables within a ompletely spe i ed e onomi model. Di erent types of un ertainty
within the model an then be spe i ed and their e e ts studied. The fa t that Taylor-type
rules have mat hed the histori al behavior of the Federal Reserve for the past 15{20 years
also lends support to their use as an analyti al laboratory for the investigation of these
issues.
A typi al setup involves an e onomy that is linear in all of its variables, and poli y-
makers who minimize an expe ted dis ounted sum of squared deviations of goal variables
from their respe tive targets. The following ba kward-looking model serves as an illustra-
tive example:1
(yt y  ) = '(yt 1y  ) (rt r ) + "t (1a)
t = t 1 + (yt y  ) + t (1b)
where yt , t , and rt refer to output, in ation, and the real interest rate in period t, y
and r denote the levels of potential output and the \natural" rate of interest onsistent
with long-run equilibrium, respe tively, and rt is set by poli ymakers at the beginning
of period t based on information available through the end of period t 1. A typi al
1 I will also onsider forward-looking models in the main body of the paper, below.
2
spe i ation of poli ymakers' preferen es is:
1
X
min (1 Æ ) Et Æs t
(s   )2 + (ys y  )2

(2)
s=t

a simple dis ounted sum of expe ted squared deviations of output from potential and
in ation from its target, , with weight pla ed on the output gap. The ase = 0
orresponds to pure in ation targeting by poli ymakers, but does not ne essarily prevent
urrent or past values of the output gap from entering poli ymakers' optimal rea tion
fun tion, sin e these variables may help fore ast future values of in ation. Note that it is
assumed in the model for simpli ity that poli ymakers have ontrol over the short-term
real interest rate, rt .
This is a simple, dis rete-time dynami programming problem with quadrati ob-
je tive and linear onstraints, the solution of whi h is well known (Sargent (1987)):
rt r = a (yt 1 y  ) + b ( t 1 ) (3)
where a and b are onstants, determined by the parameters of the model. The form of
equation (3) and the values of a and b are the same no matter what the varian es of "
and  |poli ymakers behave in a ertainty-equivalent fashion regardless of the varian e
asso iated with the laws of motion of the e onomy.
A major impli ation of this nding is that un ertainty about the level of potential
output, y, should have no e e t on the monetary poli y rule. If at time t we have
y  = y^ +  , where  is a mean-zero sto hasti disturban e and y^  Et y  , then the form
of equations (1a) and (1b) is essentially un hanged, with y repla ed by y^, "t repla ed
by "~t  "t (1 '), and t repla ed by ~t  t . Then, as before, the varian es
of "~t and ~t , and hen e the varian e of , have no e e t on the optimal poli y rule|one
simply repla es y with y^ in equation (3) and a ts as if this estimate y^ were known with
ertainty. This result is emphasized by Estrella and Mishkin (1998), and is standard in
the literature on monetary poli y rules.
To be sure, not all types of un ertainty are sterile when it omes to their e e ts
on optimal poli y. For example, if poli ymakers are unsure about the e e ts of their
3
ontrol variable rt on the e onomy, so that is sto hasti , the optimal hoi e of rt will
depend on the degree of un ertainty underlying the parameter (Brainard (1967), Sa k
(1998)). Here, the un ertainty is multipli ative with respe t to the ontrol variable, rather
than being simply additive.2 In this paper, however, I abstra t away from multipli ative
un ertainty for a number of reasons. First, it is well known that ertainty equivalen e does
not hold in the presen e of multipli ative un ertainty. Se ond, the e e ts of multipli ative
un ertainty on poli ymakers' optimal response fun tion (3) are ambiguous in sign (when
more than one oeÆ ient is sto hasti ), and found by several authors to be quantitatively
small in simulations (Estrella and Mishkin (1998), Rudebus h (1999a)).3 Finally, and
most importantly, the un ertainty whi h poli ymakers appear to be most on erned with
today is primarily additive in nature: Has there been a stru tural break in the growth
rate of produ tivity, potential output, and the natural rate of unemployment? These are
questions about the state variables of the e onomy themselves, not about the e e ts of
hoi e variables on the e onomi state.
The main point of this paper is that additive un ertainty an have important e e ts
on optimal poli y, even within a linear-quadrati framework. Suppose, for example, that
the state of the e onomy is Xt, an unobserved, possibly large ve tor.4 Suppose further that
output and in ation are observable fun tions of this unobserved state of the e onomy Xt.
Poli ymakers will behave in a ertainty-equivalent fashion with respe t to Et Xt , the ex-
pe ted value of Xt, but will use observations of output and in ation to help infer what the
value of EtXt is. This inferen e stage of the problem, be ause it is one of signal extra -
tion, is sensitive to the amount of un ertainty that is present in the observable variables
of the system. In parti ular, as the noise in the data on the output gap, yt y, in reases
relative to the signal about Xt , it is optimal to de rease the oeÆ ient on yt y in the
estimation of Et Xt , and in rease the oeÆ ient on in ation in that estimation. Thus, the
optimal poli y, when expressed as a redu ed-form fun tion of output and in ation, rather
2 Note that un ertainty about r , yt 1, and t 1 are also all additive with respe t to the ontrol
variable rt, and thus also have no e e t on the optimal poli y in (3).
3 Sa k (1998), however, nds larger e e ts of parameter un ertainty within a monthly VAR framework.
4 Some omponents of X may be observed without altering the results.
t
4
than Et Xt, is not invariant to the degree of additive un ertainty in the former variables.
It is important to note that both the rule itself and poli ymakers' estimate EtXt are fully
optimal in this framework|at every time t, poli ymakers' interest-rate hoi e and estimate
of state variables are globally optimal, and annot be improved upon in any way. This
is one of the main respe ts in whi h the present paper di ers from previous work in this
area.
Previous studies of non- ertainty-equivalen e with additive un ertainty have followed
either Smets (1998) or Orphanides (1998). Smets (1998) points out that ertainty equiva-
len e fails to hold when poli ymakers are onstrained to respond to only a limited subset of
the state variables of the system, so that the poli y rule is a onstrained optimum, rather
than a global optimum. (This restri tion makes sense, in parti ular, when the size of the
state spa e is large, as in Orphanides et al. (2000), who work with the Federal Reserve
Board's ma ro model.) Un ertainty about any of the variables in the poli ymakers' simple
rule will then lead the optimal oeÆ ients of the simple rule to hange.5
Orphanides (1998) fo uses on the fa t that the data, su h as the output gap and
in ation rate, are observed only imperfe tly in real time. By the ertainty equivalen e
prin iple, poli ymakers' optimal response in this ase is to formulate best estimates of the
output gap, Et (yt yt), and in ation, Et t , and a t as if these estimates were known
with ertainty. Orphanides and others (Aoki (1999), Rudebus h (1999a,b)) bring about
non- ertainty-equivalen e in this framework by onstraining poli y to rea t to the a tual
real-time data, rather than to the best estimates above. This naturally raises the question
as to why the a tual real-time data are not (real-time) best estimates of the true values.
For example, if yt denotes the level of potential output, and ytjt the real-time esti-
mate of the level of potential output, one would normally expe t that:
yt = ytjt + t (4)
where t is a mean-zero random variable. In this ase, ytjt = Et yt, so the real-time data is
5 Un ertainty about any state variables in the poli ymakers' simple rule will have no e e t; this
not
will be obvious from the dis ussion of the results in Se tion 2, below.
5
the real-time best estimate! The onstraint that poli ymakers rea t only to the real-time
data is then not really a onstraint at all, and the ertainty equivalen e prin iple holds.
It is only be ause Orphanides formulates the real-time data problem as one of signal
extra tion, with
ytjt = yt + t (4)0
where yt (the true value underlying the data, or signal) and t (the noise) are orthogonal
random variables, that the ertainty equivalen e prin iple is ir umvented. Note that
in (4)0, the real-time data ytjt has the property that ytjt 6= Et yt, so that it is no longer
an unbiased estimate. When the problem is modi ed in this manner, an in rease in the
varian e of t now does have an e e t on the best estimate Et yt|in parti ular, if yt and t
are normally distributed around zero, then Et yt = y2 =(y2 + 2) ytjt in the univariate
ase. Although the optimal poli y is still a ertainty-equivalent fun tion of poli ymakers'
best estimate Et yt, expressing the poli y as a fun tion of the real-time ytjt now leads to
e e ts of additive un ertainty t on the oeÆ ients in the optimal rule. It is in this respe t
that Orphanides (1998) nds an ex eption to the ertainty equivalen e prin iple.
It should be lear from the above analysis that the use of real-time data per se has
nothing to do with the non- ertainty-equivalen e demonstrated in Orphanides (1998). In-
stead, it is the introdu tion of a signal extra tion problem into the poli ymakers' inferen e
step that drives the result. The general impli ations of formulating poli ymakers' inferen e
problem in this way is the domain of the present paper. In addition, the poli ies that are
emphasized in Orphanides (1998), Orphanides et. al. (2000), and Rudebus h (1999a,b) are
not fully optimal, so that it is diÆ ult in those papers to distinguish between the e e ts
of un ertainty proper and the e e ts of un ertainty intera ted with a substantially on-
strained poli y response fun tion. In the present paper, all poli y rules and all estimation
will be fully optimal. Again, this is one of the main points of departure from previous
work.
The paper pro eeds as follows. Se tion two develops the relationship between signal
extra tion and non- ertainty-equivalen e in a simple des riptive model of the e onomy,
under both naive and rational expe tations. Se tion three extends these results to the
6
general linear-quadrati -Gaussian framework and proves the oeÆ ient attenuation result
for the general ase. Se tion four extends the basi model to allow for dynami evolution of
un ertainty, and proves that the results of se tion two are robust to this extension. Se tion
ve dis usses the results and on ludes.

2. The Basi Model

Poli ymakers have preferen es over in ation and output of the form:
1
X
min (1 Æ ) Et Æs t
(s   )2 + (ys y  )2

(5)
s=t

where  denotes poli ymakers' long-run target for the in ation rate and y denotes the
level of \potential" output onsistent with long-run equilibrium. The ase = 0 orre-
sponds to pure in ation targeting, but does not ne essarily pre lude urrent or past values
of the output gap from entering poli ymakers' optimal rea tion fun tion, sin e they may
help fore ast in ation.
For the purposes of this se tion, the unobserved \signal" variable Xt will be taken to
be a s alar. The interpretation in this ase is that the true underlying state of the e onomy
is s alar, or alternatively that Xt is an index of in ationary pressures (whi h one ould
think of as orresponding to the on ept of \ex ess demand"), this index itself being an
amalgam of a great many variables underlying the e onomy. In either ase, Xt is assumed
to evolve a ording to:
Xt = 'Xt 1 (rt r ) + "t (6a)
while the output gap and in ation are observable fun tions of this unobserved state:
(yt y) = Xt + t (6b)
t = te + Xt + t (6 )
Here r denotes the \natural" rate of interest, onsistent with long-run equilibrium, and
, , and ' are known positive parameters with ' < 1. The sto hasti disturban es "t , t ,
and t are independent of ea h other, over time, of urrent and prior values of X , y, and ,
7
and are normally distributed with onstant varian es "2, 2, and 2 , respe tively. The
variable Xt (and its past values) are never observed by poli ymakers and must be inferred
from previous observations of output and in ation. Equations (6b) and (6 ) represent the
signal extra tion aspe t of the problem, with t and t denoting noise disturban es that
are orthogonal to the underlying signal Xt.
One may assume that y is observed with ertainty, or alternatively that it is sto has-
ti ( and r are presumed to be known with ertainty, although in prin iple these re-
stri tions, too, ould be dropped). Letting y = y^ +  , where  is a random variable,6 one
an rewrite equation (6b) as:
(yt y^ ) = Xt + ~t (6b)0
where ~t  t +  . From the point of view of poli ymakers' de ision at time t, this
is equivalent to simply in reasing the varian e of t in equation (6b), so the analysis is
simpli ed, without loss of generality, by restri ting attention to that equation, and studying
the e e ts of an in rease in 2 .7
Equation (6 ) also in orporates e onomi agents' prior expe tation of the in ation
rate, te, whi h is known and xed at the beginning of period t. In prin iple, this ould
be a rational expe tation (te  Ett , where Et denotes the expe tation at the beginning
of period t, before sho ks are realized), a naive adaptive expe tation (te  t 1 ), or a
fore ast derived by some other means. In pra ti e, the spe ial linear-quadrati stru ture
of the problem is lost unless te is either a rational expe tation or a xed linear ombination
of nitely many lags of observable variables; thus, that assumption will be maintained here.
In addition, for the purposes of this se tion, it will be assumed that te is either rational
or purely naive (te  t 1 ), as this keeps the number of state variables in the model to a
6 I assume here that the error  is orthogonal to urrent and past values of X and all other variables
of the system. This is the ase, for example, when the un ertainty surrounding y is due to a regime
hange that has been known to o ur in the previous period, so that y , whi h was previously known with
ertainty, is suddenly un ertain. The more general ase, where  may be orrelated with Xt, is not diÆ ult,
and is solved in Se tions 3 and 4, below. The results there are essentially identi al to those presented here.
7 There is one ompli ation in that un ertainty about y  diminishes over time (in the absen e of new
sho ks to y ) as poli ymakers learn from observations of y and . This poses no problem, however,
be ause the separation of estimation and ontrol in this linear-quadrati framework implies that this
learning pro ess (whi h takes pla e via Kalman ltering) has no e e t on the optimal poli y (see, for
example, Bertsekas (1987), p. 292).
8
minimum.8
The timing of poli ymakers' observations and a tions is as follows. At the beginning
of period t, poli ymakers update their beliefs about Xt 1 based on observations of yt 1 , 
t 1 , and the earlier hoi e of rt 1 . Based on these updated beliefs, poli ymakers then
hoose a value of rt that minimizes the expe ted loss fun tion (5). Sho ks to the e onomy
("t , t , and t ) are then realized and the values yt and t observed. Thus, poli ymakers'
information set at time t is:
It  f ; ; ; Æ; '; "2; 2; 2 ; E0X0; Var0 X0; ; r; y; te; se; s; rs; ys j s < tg (7)
where E0X0 and Var0 X0 denote the mean and varian e of poli ymakers' prior (time 0)
distribution on X0, whi h is assumed to be normal.9
Poli ymakers update beliefs about Xt 1 via Kalman ltering. Be ause ("t ; t ; t ) is
multivariate normally distributed, this is the optimal inferen e pro edure (minimizing the
mean-squared error of the estimate), and is equivalent to Bayesian updating.10
The optimal solution to poli ymakers' problem (5), given the stru ture of the e on-
omy (6) and information set (7), is:
rt = r + a Et Xt 1 + b (te ) (8)
where a and b are positive onstants determined by the parameters of the system.11 Note
that a and b are ompletely invariant to "2, 2, 2 , and Vart Xt 1 (poli ymakers' (time t)
prior varian e on Xt 1, derived re ursively from Var0 X0 by the Kalman ltering algo-
rithm). In this respe t, the linear-quadrati problem with signal extra tion displays er-
tainty equivalen e.
8 It ise not diÆ ult to show (by introdu ing a oeÆ ient on te in (6 ) and letting it tend to one) that
when t is rational, poli ymakers an set Ett =  and Et yt = y in every period, and thus te =  in

every period. See Appendix A. Also note that the exa t pro ess by whi h agents' expe tations are formed
has no e e t on poli ymakers' period t estimate of Xt. It is only be ause of the ontrol aspe ts of the
problem that assumptions about agents' expe tation formation are required.
9 The assumption of normality is not required if we restri t poli ymakers to linear estimates of the
unobserved state Xt. Under the assumption that all disturban es and priors are Gaussian, the optimal
estimate Et Xt is linear, so the need to make this distin tion does not arise.
10 Without any assumptions regarding the distribution of (" ;  ;  ), Kalman ltering is still the optimal
t t t
linear inferen e pro edure.
11 This is most easily seen by solving the poli ymakers' problem expli itly. See Appendix A.
9
In forming the optimal estimate Et Xt 1 , however, poli ymakers do respond to the
amount of un ertainty in the problem. Their prior (time t 1, i.e., before values of yt 1
and t 1 are observed) distribution on (Xt 1; yt 1 y; t 1 te 1 ) is given by:
(Xt 1 ; yt 1 y ; t 1 te 1 ) 
2 3 2 2 3 !
' Et 1 Xt 2 (rt 1 r ) x x2 x2
N 4 ' Et 1 Xt 2 (rt 1 r ) 5 ; 4  x2 + 2 x2 5
' Et 1 Xt 2 (rt 1 r )    x2 + 2
2

where I have let x2 denote Vart 1 Xt 1 , poli ymakers' prior (time t 1) varian e on Xt 1.
Their posterior distribution on Xt 1 (after observing yt 1 and t 1 ) then has mean:
Et X t 1 = 'Et 1 Xt 2 (rt 1 r )
 2 
x2 2 x2 + 2 x2 
+ (yt y  ) 'Et 1 Xt 2 + ( rt r ) (9)
 
1 1

x4 + x2 x2 + 2  
+ (t te 1) 'Et 1 Xt 2 + (rt r )
 1 1

where   (x2 + 2)( 2 x2 + 2 ) ( x2 )2 = x2 2 + 2 x2 2 + 22 . Equation (9)
is analogous to the simpler formula for signal extra tion with one 
observable variable,

Et Xt 1 = Et 1 Xt 1 + x2 =(x2 +2 ) (yt 1 y  ) Et 1 (yt 1 y  ) , with additional terms
in the oeÆ ients that take into a ount the ovarian e between output and in ation.12
Grouping terms in (9) yields:
= 
2 2 
Et Xt 1 'Et 1 Xt 2 (rt 1 r )
x2 2
+  (yt 1 y  ) (10)
+ x  (t 1 te 1 )
2 2

12 Given the normality assumption, the formula for the best predi tor Et Xt 1 is the theoreti al regres-
sion/proje tion:
Et Xt 1 = Et 1 Xt 1 + Covt 1 (Xt 1 ; Zt 1 )(Vart 1 Zt 1 ) 1 (Zt 1 Et 1 Zt 1 )
where Zt 1  [ tyt 1 1 yte 1 ℄. This yields:
 2  1
x + 2 x2
Et Xt 1 = Et 1 Xt 1 + [ x x ℄ 2 2 (Zt 1 Et 1Zt 1)
 2 x2 + 2
whi h is the expression given in (9).
10
where the Et 1 Xt 2 term an be as aded ba kward and expressed as a fun tion of lagged
observations of y, , and r to the point where the original distribution on X0 is negligible,
as it is multiplied by a large power of '.
Note that, even though poli ymakers' optimal rea tion fun tion (8) is ertainty-
equivalent in terms of the estimate Et Xt 1, when expressed as a fun tion of present and
past observable variables (y, , and r), ertainty equivalen e in the redu ed form no longer
holds. The varian es of the additive disturban e terms enter into the oeÆ ients of (10).
For example, onsider the e e ts of an in rease in 2 on the oeÆ ients in equa-
tion (10).13 As 2 in reases, the quantity  in reases, but less than proportionately. This
implies that the oeÆ ient on yt 1 y in (10) de reases in magnitude, so that poli ymakers
pla e less weight on the observation of the un ertain output gap in forming their inferen e
about the underlying state of the e onomy. Thus, we have an example of oeÆ ient atten-
uation on the noisy or un ertain variable. In addition, the oeÆ ients on ea h of the other
variables in equation (10) in rease in absolute value: poli ymakers pla e more weight on
those variables about whi h they are relatively more ertain. In this sense, poli ymakers
be ome \less proa tive and more rea tive," responding less for efully to the urrent value
of the output gap, and more for efully to past observations of output and in ation, and the
urrent in ation rate, be ause these variables provide more reliable information about the
urrent state of the e onomy and future values of poli ymakers' goal variables, in ation
and output.14
These on lusions are not idiosyn rati to an in rease in the varian e of the additive
disturban e t . For example, an in rease in 2 , instead of 2, leads to a de rease in the
oeÆ ient on (t 1 te 1 ) in equation (10), and an in rease in the oeÆ ients on the
other variables in that equation. Exa tly analogous results (lower oeÆ ient on the noisy
13 As noted above in footnotes 6 and 7, this an be thought of as orresponding to a stru tural break in
y whi h has been known to o ur in the previous period. This auses 2 to rise for the urrent period
but not for previous periods, and hen e leaves x2 una e ted.
14 This \less proa tive" result ould be emphasized by setting up the main model with an additional lag
in equation (6 ), so that:
t = te + Xt 1 + t (6 )0
However, this ompli ates the analysis by making the signal extra tion problem a fun tion of updates of
two lags of the variable Xt instead of only one. For this reason, this approa h was not taken here.
11
variable, higher oeÆ ients on the others) obtain in response to an in rease in x2 , the
poli ymakers' prior varian e on Xt 1. Thus, the result des ribed above is robust, and
derives not from any spe ial assumptions surrounding the model, but rather from the
general prin iple that in linear regression, or statisti al proje tion, less weight is given to
observations that have higher varian e.
Obviously, as with linear regression and statisti al proje tion, the ovarian es be-
tween the di erent variables matters for the oeÆ ients in (10). So far, I have abstra ted
away from this problem by assuming that the disturban es are orthogonal to ea h other,
and to poli ymakers' prior for the variable Xt 1, but I show below for the general ase, with
arbitrary ovarian es, that the basi oeÆ ient attenuation result still holds: an in rease
in the un ertainty surrounding a given variable auses poli ymakers to assign less weight
to that variable in forming their best estimate of the underlying state of the e onomy,
Et Xt 1 . Moreover, the ampli ation of the oeÆ ients on in ation and its lags in (10)
is also quite robust, and holds for models more general than that of the present se tion.
For example, se tion 4 proves this result for the ase where in reased un ertainty about
potential output extends ba kward any number of periods, is orrelated a ross time, and
is orrelated with poli ymakers' priors about the unobserved state of the e onomy Xt 1,
in a manner whi h is onsistent with poli ymakers learning about potential output over
time.
Finally, the dire tion that the oeÆ ients in equation (10) move an be ambiguous
when one in reases the varian e of more than one variable at a time. For example, in reas-
ing 2 and x2 simultaneously auses the oeÆ ient on the una e ted variable (t 1 te 1 )
to in rease unambiguously, but the e e t on the other two oeÆ ients is not lear.15 I will
return to this issue in se tion 4, below, but will remove the ambiguity by making use of
the expli it relationships between x2 and past values of 2 that arise from the Kalman
ltering algorithm.
15 Although if 2 in reases by more than x2 , it is easy to show that the oeÆ ient on (yt 1 y ) must
de rease in magnitude, while if x in reases by more than  , then the oeÆ ient on Et 1Xt 2 must
2 2
de rease in magnitude.
12
2.1 Signal Extra tion vs. Imperfe t Observation of State Variables
It is important to note that the above results hinge ru ially on setting up model (6) as
one involving signal extra tion, rather than one simply involving imperfe t observation of
state variables. For example, repla ing (6b) with:
X t = (yt y  ) + t (6b)y
or, with an un ertain potential output:
Xt = (yt y^ ) + ~t (6b)z
where y  y^ +  and ~t  t  , the non- ertainty-equivalen e results des ribed above
are ompletely eliminated. In both (6b)y and (6b)z, the poli ymakers' optimal estimate
of the underlying state of the e onomy, Et Xt 1 , is simply (yt 1 y ) in the rst ase,
and (yt 1 y^) in the se ond. Plugged into the ertainty-equivalent stru tural response
in equation (8), the redu ed-form poli y response thus retains the ertainty equivalen e
property.
Note that this analysis implies that it is not real-time data per se that justi es
aution on the part of poli ymakers in Orphanides (1998) and Rudebus h (1999a). If the
real-time data are unbiased fore asts of the true values, analogous to (6b)y or (6b)z, then
ertainty equivalen e holds, and the amount of un ertainty surrounding these real-time
estimates (2) is ompletely irrelevant for optimal poli y. Certainty equivalen e only fails
to hold in their framework if the real-time data are realizations of true values plus noise
(and thus are biased estimates of the true values), so that estimation of the true values
involves a signal extra tion problem, as in (6b).
This naturally raises the question as to whether the real-time data are better mod-
eled as rational estimates or as noise- ontaminated observations. Orphanides (1998, 1999)
presents gures demonstrating that the output gap, in parti ular, has been badly mis-
measured by poli ymakers in real time. However, both the size of these errors and their
serial orrelation were not evident until several years after the fa t, so it is not lear that
13
these real-time estimates of the output gap were not rational at the time. To take the
position that poli ymakers were deliberately irrational in their real-time estimates seems
unwarranted without a more rigorous analysis to support this point of view.
Rigorous analysis of the performan e of real-time data and oÆ ial fore asts has been
undertaken by a number of authors, albeit with data that is more readily observable than
the output gap, su h as real GDP and in ation. Mankiw and Shapiro (1986) analyze
whether the real-time real GNP data produ ed by the BEA is better modeled as a rational
fore ast or as a realization with noise of the \true" (i.e., \ nal release") value. They nd
that the real-time data appear to be unbiased and eÆ ient rational fore asts. M Nees
(1995) looks at the oÆ ial fore asts of real GNP/GDP and in ation published by the
CBO and Federal Reserve System (as presented in \Humphrey-Hawkins" reports) and
nds that they perform at least as well, if not better, than private-se tor fore asts in terms
of mean-squared error. Romer and Romer (2000) nd that not only are the Federal Reserve
Board's internal \Greenbook" fore asts of output and in ation unbiased and eÆ ient, they
ompletely dominate private se tor fore asts, in the sense that the private se tor fore ast
should be thrown out entirely if the Board's fore asts were to be made publi .
These results might at rst seem to ontradi t Rudebus h's (1999a) nding of a
signi ant, irrational \noise" omponent in the real-time in ation data (as measured by
either the GNP/GDP de ator or xed-weight pri e index). However, as in Orphanides
(1998, 1999), Rudebus h's \ nal" data is from the perspe tive of the late 1990's, and thus
in ludes de nitional revisions to GNP and hanges in base year. In ontrast, all of the
papers ited above take parti ular are to evaluate the performan e of the fore asts with
respe t to a nal measure of the statisti on a de nitionally onsistent basis. For example,
it seems unfair to evaluate the rationality of poli ymakers' 1970 estimate of real GNP and
in ation using today's estimates of 1970 GDP in hain-weighted 1996 dollars, yet this is
exa tly what Orphanides and Rudebus h do. Thus, it is likely that the \noise" found by
Rudebus h (1999a) re e ts nothing other than de nitional hanges in the data rather than
deviations from rationality in poli ymakers' estimates.16
16 The problem of de nitional revisions to output and in ation does raise an interesting theoreti al issue:
14
The ase for biased real-time data is thus somewhat un ompelling from an empiri al
as well as a theoreti al standpoint. This implies that models in orporating only real-time
data un ertainty should be ertainty-equivalent. However, framing poli ymakers' inferen e
problem about the state of the e onomy as one of signal extra tion more generally, as is
done in this paper, is still quite plausible. The interpretation of poli ymakers' estimation
pro ess in this ase is one of an unobserved, possibly ompli ated state of the e onomy
that must be inferred using (possibly a large number of) observable e onomi indi ators.
For example, Chairman Greenspan is renowned for looking at a wide variety of e onomi
statisti s in an attempt to infer the urrent state of the e onomy and its future ourse.
Alternatively, one ould think of the unobserved e onomi state X as being an aggregate
on ept su h as \ex ess demand," with poli ymakers performing signal extra tion using a
number of utilization and in ation measures in an attempt to infer what the level of ex ess
demand is. When poli ymakers fa e signal extra tion problems like these, as in the model
above and the general framework below, a strong ase for aution in the fa e of un ertainty
an still be made.
2.2 CoeÆ ient Attenuation, Simple Rules, and Robust Control
The impli ations of this paper ontrast in an interesting way with those from the literature
on \simple rules" and \robust ontrol." In parti ular, the signal extra tion framework of
the previous se tion found that an in rease in un ertainty surrounding a given indi ator
variable should be met with an attenuation in poli ymakers' response oeÆ ient to that
variable, and an ampli ation of their response oeÆ ients on all other indi ators, about
whi h un ertainty hasn't hanged.17
While it is fairly lear that the rationality of a fore ast should be evaluated using de nitionally onsistent
realizations of the statisti , it is not so obvious that this is the orre t approa h when we start to onsider
poli ymakers' welfare. For example, it is possible that the post-de nitional- hange statisti is a better
measure of the loss poli ymakers, and so iety, a tually experien ed.
I would, however, take the following view. Poli ymakers' losses are a fun tion of the true underlying
state of the e onomy. The various aggregate statisti s are generally poor re e tions of this state. A
de nitional hange in one of the aggregate statisti s hanges the relationship between the true state of
the e onomy and the given aggregate statisti , but does not hange the true state of the e onomy itself.
Thus, the optimal oeÆ ients in poli ymakers' signal extra tion problem should hange in response to the
de nitional revision, but there is not any irrational \noise" in the real-time data or in poli ymakers' losses.
17 In the ompletely general setup of the model (se tion 3), only the oeÆ ient attenuation result on
15
The literature on \simple rules," in ontrast, generally nds that poli ymakers
should attenuate their response oeÆ ients on all variables in their rea tion fun tion,
even if the in rease in un ertainty surrounds only a single variable.18 This literature,
typi ed by Smets (1998), onsiders optimal poli y within a lass of rules that rea t to
only a limited subset of state variables in the model. Be ause these simple rules are not
globally optimal, they typi ally do not possess the ertainty equivalen e property. Thus,
observation error on a variable, even of the type in (6b)y and (6b)z, will generally lead to
non- ertainty-equivalent behavior in these onstrained-optimal rules.
For example, Smets (1998) restri ts poli ymakers to rules involving only one lag of
output, the four-quarter average in ation rate, and one lag of the interest rate as argu-
ments, and nds that the optimal oeÆ ients on all of these variables are attenuated by
an in rease in un ertainty surrounding the output gap. Orphanides et al. (2000), investi-
gating a similarly- onstrained lass of rules within the Federal Reserve Board's FRB/US
model, also nd that attenuating the oeÆ ients on every variable in the rule is the best
response to in reased un ertainty surrounding the output gap.19 The reason that these
ndings di er from those of the present paper an be explained as follows. The optimal
rule in all of these models is a fun tion of multiple lags of the output gap, in ation, and
interest rates (and, in the FRB/US model, many other variables as well). To the extent
that these variables are omitted, those that enter the simple rule serve partially as proxies
for the variables that have been ex luded. If the four-quarter average in ation rate enters
negatively into an estimation equation for some of these other terms (su h as past values
the un ertain variable holds unambiguously. However, both in the simple framework (6) above and its
generalization to un ertainty extending ba kward any number of periods below (se tion 4), ampli ation
of oeÆ ients on the other variables, about whi h un ertainty hasn't in reased, holds generally.
18 Drew and Hunt (2000) is one ex eption to this rule, but their model and ndings are idiosyn rati for a
number of reasons. First, the RBNZ's ma ro model is signi antly nonlinear, so that ertainty equivalen e
would fail to hold even with a fully optimal rule. Se ond, and more importantly, poli ymakers' estimate
of potential output is irrational, using an HP- lter that yields estimates that are signi antly orrelated
with the business y le. Poli ymakers thus have a strong in entive to rea t aggressively to the output gap
estimated in this way, sin e it will generally be smaller than the true output gap that enters their loss
fun tion.
19 Orphanides et al. do nd that under some ir umstan es an ampli ation in the oeÆ ient on the
in ation rate is optimal. However, this only o urs when they in rease the relative weight on the output
gap in poli ymakers' loss fun tion to high levels (0.75 or above).
16
of the interest rate), then the desired ampli ation in oeÆ ients on urrent and past in-
ation that I nd will be o set by the desired ampli ation in the oeÆ ients on these
additional lagged output, in ation, and interest rate terms, making the overall e e t on
the in ation oeÆ ient ambiguous.20
Finally, the emerging literature on \robust ontrol" arrives at just the opposite
on lusion: poli ymakers ought to respond more aggressively to every variable in their
rea tion fun tion when fa ed with model un ertainty. This literature, typi ed by Onatski
and Sto k (2000), hooses oeÆ ients of a poli y rule to minimize the maximum loss over
all possible values for a given parameter within a given range; thus, the poli ymaker is
guaranteed not to make mistakes that are extremely ostly for parameters within this
range. This approa h is learly very di erent from the maximization of expe ted value
approa h I have taken here, so it is not surprising that the results di er. Intuitively, their
ndings are driven by the fa t that a bad draw on the e e tiveness of the poli y tool (the
parameter in my model) an result in very large losses if the rule's responsiveness is not
suÆ iently great. However, it is not lear that an in rease in additive un ertainty about
potential output would lead to the same on lusions.

3. Signal Extra tion in the General LQG Framework

In this se tion, I solve the poli ymakers' signal extra tion and optimization problem for
the general linear-quadrati -Gaussian framework, and provide the relevant proofs.
As before, I denote the underlying state of the e onomy by Xt, whi h may now be a
ve tor. Xt evolves a ording to a linear fun tion of one lag of itself and a ve tor of poli y
instruments rt . Thus,
Xt = AXt 1 + Brt + "t (11)
20 There are some other minor di eren es at work as well. For example, Smets evaluates the e e ts
of in reases in the varian e of the output gap that go ba k into the in nite past, while the experiment
onsidered in this se tion has been more losely related to a hange in regime or stru tural break at a
given point in time t. However, I show in se tion 4, below, that the results of this paper ontinue to
hold when un ertainty about the output gap extends ba kward any number of periods. Also, Smets and
Orphanides et al. onstrain their simple poli y rules to be fun tions of in ation deviations from target (the
four-quarter moving average of (t 1 )) rather than the in ation surprise (t 1 te 1) whi h would
be loser to the optimal inferen e pro edure I derive in equation (10).
17
where A and B are known matri es of the appropriate dimensions. Any onstants an
be in orporated by de ning one omponent of Xt to be a ve tor of ones. I denote the
observable variables of the system by Zt . These may be a subset of the variables in Xt,
noisy realizations of a linear fun tion of variables in Xt , or some ombination of the two.
Thus,
Zt = CXt + t (12)
where C is a known matrix of appropriate dimension, with every observable relationship
among the elements of Xt orresponding to a row in (12). The noise ve tor t may have
some omponents that are always zero, orresponding to elements of Xt that are a tually
observed. Other omponents of Xt, that are not dire tly observed, must be inferred from
observations of Zt .21 Note that (12) has been set up as a signal extra tion problem rather
than one of imperfe t observation (in whi h ase Xt would be a fun tion of the observable
variables Zt plus disturban e terms). The latter would exhibit ertainty equivalen e; the
former does not (with respe t to the observable variables).
The sto hasti disturban es "t and t are assumed to be independent of ea h other,
over time, of urrent and past values of r, X , and Z , and are (multivariate) normally
distributed with onstant varian e- ovarian e matri es " and  , respe tively.22 In pra -
ti e, these assumptions are not as restri tive as it might seem, be ause serial orrelation
and ross- orrelation of t and "t an be introdu ed by in luding lags of these variables as
elements of Xt , and rede ning the disturban es in (11) and (12) to be orthogonal innova-
tions to these pro esses.23 Correlation between t and Xt an be introdu ed in a similar
fashion.
21 It should be noted that equations in (12) that are redundant, or are not informative about Xt, in the
sense that poli ymakers' prior varian es on the orresponding elements of Zt are zero, should be dropped
from (12). Intuitively, realizations of these omponents of Zt ontain no new information, and thus are
irrelevant for0 updating poli ymakers' beliefs about Xt. Mathemati ally, this ensures that the matrix
C t 1jt 1C +  is nonsingular in the updating equations below.
22 No diÆ ulties arise when one allows  and  to vary over time, so long as this variation is inde-
" 
pendent of the poli y instrument.
23 Aoki (1967), for example, makes this observation (pp. 38{39).
18
Poli ymakers minimize a quadrati loss fun tion:
1
X
min (1 Æ ) Et Æ s t Xs0 DXs (13)
s=t

where D is a positive semide nite matrix. Note that this spe i ation does not pre lude
poli ymakers' preferen es from depending on observables Z , sin e X an be expanded to
in lude elements of Z as needed. Past values of r an also be in orporated into X and Z .
Poli ymakers hoose a value for the ve tor of instruments rt at the beginning of ea h
period t, onditional on all information available through the end of period t 1. After
rt is hosen, the sho ks "t and t are realized, and the value of the ve tor Zt is observed.
Poli ymakers' information set at the beginning of period t is thus:

It  fA; B; C; D; Æ; ";  ; E0X0; Var0 X0; Zs j s < tg (14)

where E0X0 and Var0 X0 denote the mean and varian e of poli ymakers' prior (time 0)
distribution on X0, whi h is assumed to be normal.
Poli ymakers update beliefs about Xt via Kalman ltering, whi h is the optimal
inferen e pro edure given the assumptions of normality above. Letting sjt denote Vart Xs,
the varian e of Xs onditional on information available at the beginning of period t, we
have the re ursive equations:

Et 1 X t 1 = A Et 1Xt 2 + Brt 1 (15a)
Et 1 Z t 1 = C Et 1 Xt 1 (15b)
Et X t 1 = Et 1 Xt 1 + t 1jt 1C
0 C t 1jt 1 C 0 +   1
Zt 1 Et 1 Z t 1

(15 )
t 1jt 1 = At 2jt 1A0 + " (16a)
t 1jt = t 1jt 1 t 1jt 1 C 0 C t 1j t 1 C
0 +   1 C t 1jt 1 (16b)

Note that the varian e tjt evolves deterministi ally over time, as is typi al in the LQG
framework. In parti ular, the varian es of poli ymakers' future estimates are una e ted by
19
their hoi e of the urrent instrument rt .24 This leads to separability between the estima-
tion and ontrol stages of poli ymakers' problem, and hen e to the ertainty equivalen e
result of the following proposition.
Proposition 1: The optimal solution to poli ymakers' problem (13), subje t to the law
of motion (11), observation equation (12), and information set (14) is given by:
rt = (B 0 V B ) 1 B 0 VA Et Xt 1 (17)
where V is the \value" matrix, de ned to be the unique negative semide nite solution to
the Ri ati equation
V = D + ÆA0 VA ÆA0 V B (B 0 V B ) 1 B 0 VA (18)
Proof: Bertsekas (1987), pp. 292{293.
Equation (17) is ertainty-equivalent with respe t to the state variable Xt 1. How-
ever, as should be lear from the previous se tion, ertainty equivalen e generally will not
hold with respe t to the observable variables Zt 1 . The following proposition demonstrates
this fa t by proving the oeÆ ient attenuation result from the previous se tion for the gen-
eral LQG framework. Note that by holding t 1jt 1 xed in what follows, the model is
onsistent with the interpretation that a stru tural break in the degree of un ertainty
surrounding the indi ator variables has o urred in the previous period.
Proposition 2: Suppose that the varian e of the rst omponent of t 1 in (12) is in-
reased, in the sense that element (1; 1) of  is in reased while all other elements of  ,
and all elements of t 1jt 1 in (15) and (16), are held xed. Then poli ymakers' optimal
response to observables, obtained by substituting (15) into (17), exhibits an attenuation in
the response of all elements of poli ymakers' instrument rt to the rst omponent of Zt 1 .
Proof: Re all that rt is a ve tor of instruments, hen e the proposition states that the
optimal setting of ea h of these is attenuated with respe t to the rst omponent of Zt 1 .
This is intuitive be ause the ordering of the elements of rt is arbitrary.
24 The poli ymaker's hoi e of rt does not a e t the signal extra tion aspe ts of the problem|neither
the varian e of s nor the varian e of Xs for any s  t|be ause it is assumed that the oeÆ ient matri es
A and C are known with ertainty. This is in marked ontrast to the \experimentation" motive that
is present in Wieland (1998), where poli ymakers' hoi e of rt helps to resolve the Brainard un ertainty
about the multipli ative parameters of the model.
20
Let M denote the positive de nite matrix C t 1j t 1 C
0 +  in equation (15), and
partition M into:  
M11 M12
M21 M22
where M11 is a s alar, M21 a olumn ve tor, and M12 = M210 . Letting N denote M 1 and
partitioning N in a ordan e with M , we have:
 
jM22j=jM j M111 M12 N22
N= (19)
M221 M21 N11 M221 + M221 M21 N11 M12 M221
Let M11 be multiplied by a fa tor  > 1, orresponding to the in rease in  . Then
jM j in reases in magnitude be ause, expanding along the rst row or olumn, jM j =
M11 jM22 j + S , where S is a sum of element- ofa tor produ ts not involving M11 , and M11 ,
jM22j, and jM j are positive. Thus, N11 is attenuated, and it follows from (19) that N21 is
attenuated in the same proportion, say by the fa tor  < 1. Thus the rst olumn of N is
attenuated by the fa tor .
Inspe tion of (18) reveals that V is invariant to the hange in  , and by the in-
varian e of the other parameters in (15), (16), and (17), it follows that the rst olumn of
(B 0V B ) 1B 0VA t 1jt 1C 0 C t 1jt 1 C 0 +  1 is attenuated by the same fa tor .
These are exa tly the oeÆ ients in question, ompleting the proof.
One would like to be able to in rease the ovarian es among the omponents of t
as well, but unfortunately, ompletely general statements in this ase annot be made.

4. Signal Extra tion Dynami s in the Basi Model

The analysis of the pre eding se tions has been essentially stati in nature, in that a
stru tural break in un ertainty was known to have o urred in the previous period. It
is not lear, then, that the results still apply if the in rease in un ertainty o urs several
periods earlier, parti ularly when we take into a ount the fa t that in reased un ertainty
about potential output feeds through to in reased un ertainty about subsequent estimates
of X , the unobserved state of the e onomy. Moreover, errors in poli ymakers' estimates
of potential output and X are serially orrelated, as poli ymakers learn about mistakes in
21
their estimates only slowly over time. A proper treatment of the basi model in se tion 2
would take these dynami aspe ts of poli ymakers' un ertainty into onsideration.
Thus, the model here will be essentially the same as in se tion 2. Poli ymakers'
preferen es are assumed to be of the form:
1
X 
min (1 Æ ) Et Æs t s2 + ys2 (20)
s=t

where, for ease of notation, s now denotes the deviation of in ation from poli ymakers'
target and ys denotes the output gap, both at time s. The e onomy is assumed to follow:
Xt = 'Xt 1 rt + "t (21a)
yt = Xt + t (21b)
t = te + Xt + t (21 )
where Xt denotes the unobserved state of the e onomy, rt the deviation of the real interest
rate from its \natural" value, and te agents' expe tation of in ation, as before.
Unlike the earlier model, I now allow the error term  to be persistent:
t = t 1 + t (21d)
where  is the degree of persisten e of sho ks to potential output.25 The normally dis-
tributed disturban es "t , t , and t are assumed to be orthogonal to ea h other, a ross
time, and to all other variables in the system.
The timing of poli ymakers' observations and a tions is the same as in se tion 2,
with information set
It  f ; ; ; Æ; ; '; "2; 2; 2; E0X0 ; Var0 X0; te; se; s; rs; ys j s < tg (22)
25 This interpretation is lear if we repla e (21b) with
yt = Xt + t + t (21b)0
where t represents sho ks to potential output with persisten e , and t represents white-noise sho ks
to the output gap relative to the state of the e onomy. Clearly, poli ymakers' problem in this ase is
essentially identi al to that given in the text, so I have retained the more parsimonious model there.
22
Poli ymakers' optimal solution to (20), subje t to (21) and (22), is given by:
rt = aEt Xt 1 + bEtt 1 + te (23)
where a, b, and are onstants invariant to the un ertainty surrounding X and  (see
Appendix A). In ontrast to se tion 2, poli ymakers now are about past values of  as
well as X . Note that be ause yt 1 = Xt 1 + t 1 , we an rewrite (23) as:
rt = a~Et Xt 1 + byt 1 + te (24)
where a~  a b.
As values of y and  are observed, poli ymakers update their beliefs about X and 
by Kalman ltering. Letting x2t , 2t , and xt denote VartXt , Vartt , and Covt(Xt ; t ),
respe tively, poli ymakers' best estimate of Xt 1 at time t is given by:

Et X t = 2 2t 1+ xt 1
Et 1 X t
1
t 1 1

+ 2 x2t1+ xt 1
yt (25)
t 1 1

x2t 1 2t x
2 
+ t
1 t 1 t 1 te 1
1

where t  2 x2t 2t x2 t  + 2 x2t+ 2xt+ 2t  for all t. Equation (25) was derived
exa tly as was poli ymakers' estimation equation (10) in se tion 2. The Et 1Xt 1 term
an be written as 'Et 1Xt 2 rt 1 and as aded ba kward, as before.
Given an exogenous in rease in un ertainty about s at the beginning of period
s < t, we must begin by tra ing out its e e ts on subsequent values of 2 , x2 , and x .
The interpretation of the exogeneity of the in rease in 2s is that of a stru tural break in
un ertainty surounding potential output in period s. The ase where un ertainty about 
in reases exogenously in several periods s1 ; s2; : : : ; sk , while perhaps more interesting, is
simply a positive linear ombination of the e e ts given below, and thus does not need to
be onsidered separately.
23
A straightforward omputation (using equations (16) from the previous se tion)
shows that poli ymakers' varian es evolve a ording to:26
 2
xt+1 xt+1

2 (x2t 2t x2 )
' 2 '
  2
 0 

xt+1 2t+1
= t
t
' 2 + 0 2
" (26)
For notational onvenien e, de ne
 2 ( 2  2  2 )
Nt   xt t xt
t (27)
whi h is the key term in (26). Totally di erentiating Nt with respe t to 2s , using (26),
yields
dNt 4  2 2 dN
=
ds t
2 2  (xt+ xt ) + ' (t+ xt )
2 t 1
d2s
(28)
whi h is a re ursive sequen e terminating with:
dNs Ns
d2s
=  2
s (29)
 2
4
=  ( + xs )2
2 xs
s
The rst equality in (29) follows from the assumption that the in rease in un ertainty about 
s in period s is exogenous, while the ovarian e xs and varian e x2s , whi h derive from
un ertainty about  and X in prior periods, are held xed.
Note that equations (28) and (29) imply dN =d2s  0 for all   s. This fa t,
together with the relations implied by (26), helps us assess the e e ts of the break in
un ertainty about s on the oeÆ ients in the period-t estimation equation (25).
For example, the oeÆ ient on the most re ent in ation surprise, (t 1 te 1 ),
unambiguously in reases in (25). This follows from the fa t that:
d (x2t 1 2t 1 x
2
t 1
) = dNt 1 > 0
ds
2 t 1 2 d2s
and the oeÆ ient on the in ation surprise in (25) is positive. Thus, the nding of an
ampli ation of the oeÆ ient on in ation in se tion 2 is robust to extending the in rease
in un ertainty about the output gap ba kward any number of periods.
26 Note that Xt and t are orrelated, sin e t 1 = yt 1 Xt 1 . Hen e Covt (Xt 1 ; t 1 ) = Vart Xt 1
and Covt(Xt; t ) = ' Vart Xt 1.
24
Similarly, the oeÆ ient on the most re ent output gap, yt 1 , is ne essarily attenu-
ated, under the assumption that  > ' (whi h orresponds to assuming sho ks to potential
output are more persistent than movements in the output gap):
d 2 (x2t 1+ xt 1 )
d2s t 1
2   
= 2 (' )2 2 (x2t 1+ 'xt 1 ) x2t 1+ ( + ')xt 1+ '2t 1 dN t 2
d 2
t 1 s
2   
=  ( ')2 + 2 "2 "2 + '2 dN
2
t 2
d2s
<0
t 1
Thus, this nding from se tion 2 is also robust, no matter when the stru tural break in
un ertainty o urred.27
The oeÆ ient on the lagged estimate of the state variable, Et 1Xt 1 , may either
in rease or de rease in (25), a ording to:
d 2 (2t 1+ xt 1 )
d2s t 1
2    dN
= 2 ( ') ('t 1+ xt 1 ) xt 1+ ( + ')xt 1+ 't 1 dt2 2
2 2 2 2 2
t 1 s
2   
=  ( ')2 2 '2 "2 + '2 dN
2
t 2
d2s
t 1
whi h is positive if and only if ( ') > 2 '2 =2 .28 CoeÆ ients on lags of in ation
and unemployment, obtained by as ading the expe tational term ba kward in (25), may
thus also go either way, depending on the sign of the derivative above. For example, if
( ') > 2 '2 =2 , then the oeÆ ient on E X in reases for every   s. It then
follows that the oeÆ ient on the lagged in ation surprise ( e ) also in reases for
every   s (although the hange in oeÆ ient on lags of the output gap, y , is not lear
for s    t 2). If ( ') < 2 '2=2 , then the oeÆ ient on E X de reases for every 
 s, the oeÆ ient on y also de reases for every   s, and the hange in oeÆ ient on
( e ) now be omes analyti ally un lear for s    t 2.
27 Te hni ally, this is only attenuation under the assumption that poli ymakers' optimal response to the
output gap, b + 2 (x2t 1+ xt 1 )=t 1, is positive. This assumption seems warranted (it an be shown
that b > 0, for instan e).
28 The oeÆ ient on E
t 1 Xt 1 in (25) is ne essarily positive, assuming again that  > ' (and one an
show that a~ > 0 in any ase).
25
Note that I use the terminology \not lear," rather than \ambiguous," here be-
ause the hange in oeÆ ients may be theoreti ally unambiguous, but omputation of the
analyti al derivatives and a further sign he k of the result would be required to as er-
tain this fa t, and these omputations qui kly be ome very burdensome. For example, it
an be shown analyti ally that the oeÆ ient on the se ond lag of the in ation surprise,
(t 2 te 2 ), also ne essarily in reases for  > ' (no matter what the value of 2 '2=2 ),
further orroborating the nding that poli ymakers should rea t more aggressively to in-
ation.

5. Con lusions

A standard result in the literature is that optimal monetary poli y in a linear-quadrati
framework is ertainty-equivalent. It was emphasized in this paper that optimal poli y
is not ertainty-equivalent with respe t to observable variables when poli ymakers fa e a
signal extra tion problem in their estimation of the e onomi state. For example, the state
of the e onomy may be very ompli ated, and poli ymakers may have only a relatively
small number of aggregate statisti s to help them infer what the state of the e onomy
is. Alternatively, the state of the e onomy ould be regarded as an unobserved aggregate
on ept su h as \ex ess demand," with poli ymakers using various measures of utilization
and in ation to help them infer what the level of ex ess demand is. In both ases, in reased
un ertainty about an indi ator variable auses poli ymakers' optimal rea tion oeÆ ient
on that variable to be attenuated. I also nd that, in the fairly standard model above,
it is optimal for poli ymakers to amplify their rea tion oeÆ ients on all other e onomi
indi ators, about whi h un ertanity hasn't hanged.
It is important to note that signal extra tion is ru ial to the above results. If
instead of a signal extra tion problem, poli ymakers fa e simply imperfe t observation of
state variables, so that the state is perfe tly observed up to a white-noise error term, then
the ertainty equivalen e property holds, even with respe t to observable variables.
The real-time data literature of Orphanides (1998), Rudebus h (1999a,b), and others
should be regarded as a spe ial ase. In those papers, if the real-time data are rational
26
estimates of the underlying true values, then poli y should be ertainty-equivalent, even
with respe t to the real-time data. However, if the real-time data are known to ontain
an irrational noise omponent, then poli ymakers fa e a signal extra tion problem in their
estimation of the true values, and ertainty equivalen e will no longer hold with respe t to
the observable, real-time data.
In general, I nd that poli ymakers should take into a ount the unobserved na-
ture of the e onomy when applying the ertainty equivalen e prin iple. In parti ular, it
should be kept in mind that the prin iple does not apply to poli ies that are expressed in
terms of observable e onomi variables when a signal extra tion problem is involved in the
estimation of the e onomi state.
27
Appendix A: Solution to the Basi Model

Here I solve the basi model of se tion 2 under both naive expe tations (te  t 1 ) and
rational expe tations (te  Et t). Re all that the model's basi equations are given by:
Xt = 'Xt 1 (rt r ) + "t (A1)
(yt y) = Xt + t (A2)
t = te + Xt + t (A3)
The solution under naive expe tations is standard (e.g., Sargent (1987)), and is given by:
rt = r + a Et Xt 1 + b (t 1 ) (A4)
where      
a = (B 0 V B ) 1B 0 V A; A 0
' (A5)
b 1 ; B 
'
and V is the unique negative semide nite solution to the Ri ati equation:
 
0 0 0
V = D + ÆA V A ÆA V B (B V B ) B V A; 1 0
D 0 1 0 (A6)
In parti ular, the solution (A4) is ertainty-equivalent, in that a and b are invariant to the
se ond and higher moments of the sto hasti parameters of the system.
For the solution under rational expe tations, it is easiest to think of repla ing (A3)
with
t = te + Xt + t (A3)0
and onsider the limit as  tends to one. Under both dis retion and ommitment, the
dynami s of the problem in this ase are trivial, be ause it has no persisten e (poli-
ymakers an set Xt up to a sto hasti disturban e term, and t is a jump variable).
Poli ymakers' problem in period t thus redu es to minimizing the period-t loss fun tion
 
Et (yt y  )2 + (t   )2 .
When poli ymakers are short-sighted (\dis retionary"), taking te as xed, it is easy
to show that optimization and rational expe tations lead to:
2 (1 )
Et t = 2 ; Et (yt y  ) = 2  (A7)
+ (1 ) + (1 )
28
whi h onverge to  and 0, respe tively, as  ! 1.
Alternatively, when poli ymakers are far-sighted (\ ommitted"), optimization and
rational expe tations lead to:
2 (1 )
Et t = 2 ; Et (yt y  ) = 2  (A8)
+ (1 ) 2 + (1 )2
whi h likewise onverge to  and 0 as  ! 1.29
Thus, under rational expe tations, we an regard poli ymakers as solving the fol-
lowing more standard linear-quadrati problem:
Xt = 'Xt 1 (rt r ) + "t (A9)
(yt y) = Xt + t (A10)
t =   + Xt + t (A11)
for whi h the optimal solution is:
rt = r + a Et Xt 1 + b (  ) (A12)
where a and b are given by equation (A5), exa tly as before. Obviously, the (  ) term
an be dropped, but leaving it fa ilitates omparison to (A5) and the single solution given
in the main body of the text,
rt = r + a Et Xt 1 + b (te ) (A13)
It is then not hard to solve expli itly for V in (A6) and show that a and b are
ne essarily positive.
The same methods an be applied to the slightly more ompli ated model of se -
tion 4.

29 This is not surprising, sin e setting t =  and (yt y ) = 0 in expe tation is the global optimum,
and this was a hieved even under dis retion.
29
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