748 Michael Woodford

they do not evaluate Eq. (6) conditional upon the actual initial conditions at the time of
the policy choice. Instead, they proposed that in the case of each candidate policy rule, the unconditional
expectation of Eq. (6) should be evaluated, integrating over all possible initial conditions (xt0—1 ¼ 0) using the
ergodic distribution associated with the stationary rational-expectations equilibrium implied by the time-
invariant policy rule in question. This is a criterion that allows a particular policy rule to be chosen simply on
the basis of one’s model of the economy (including the stochastic process for the exogenous dis- turbances),
and independently of the actual state of the world in which the choice is made. But note that a time-
independent outcome is achieved only by specifying that each time policy is reconsidered, Eq. (6) must be
evaluated under fictitious initial condi- tions — a sort of “veil of ignorance” in the terminology of Rawls
(1971) — rather than under the conditions that actually prevail at the time that the policy is reconsidered. If one
is willing to posit that candidate policies should be evaluated from the standpoint of fictitious initial conditions,
then the choice of Eq. (21) can also be justified in that way: one would choose to conform to the target criterion
(21) for all t ≤ t0, if one eval- uates this rule (relative to other possibilities) under the fictitious initial
condition
27
xt —1 ¼ 0, regardless of what the actual value of xt —1 may have been. (Note that if

xt0—1 ¼ 0, Ramsey policy requires precisely that Eq. 21 holds for all t ≤ t0.)
Thus the preference of Blake (2001) and Jensen and McCallum (2002) for the alter- native rule (25) depends on
their preferring to evaluate the loss function under alterna- tive (but equally fictitious) initial conditions. While
they might argue that the choice of the ergodic distribution is a reasonable choice, it has unappealing aspects. In
particular, the probability distribution over initial conditions that is assumed is different in the case of each of
the candidate rules to be evaluated, since they imply different ergodic distri- butions for (xt—1, ut), so that a given
rule might be judged best simply because more favorable initial conditions are assumed when evaluating that
rule.28
Moreover, the criterion proposed by Blake (2001) and Jensen and McCallum (2002) leads to the choice
of a different rule than does “optimality from a timeless per- spective (as previously defined) only to the extent
that the discount factor b is different from 1. (Note that as b ! 1, the criteria (21) and (25) become identical.)
Since the empirically realistic value of b will surely be quite close to 1, it is not obvious that the
alternative criterion would lead to policies that are very different quantitatively.
2.6 Consequences of the interest-rate lower bound
In the preceding characterization of optimal policy, it has been taken for granted that the evolution of the
nominal interest rate required for the joint evolution of inflation
27
More generally, if xm 6¼ 0, the required fictitious initial condition is that xt —1 ¼ xm.
Benigno and Woodford (2008) proposed a solution to the problem of choosing an optimal policy rule within some class of “simple” rules, under which
the same probability distribution over initial conditions is used to evaluate all
rules within the candidate family of rules.

Optimal Monetary Stabilization Policy

simultaneously stabilize all four variables, even in the absence of variation in the cost-
push terms, if there is exogenous variation in the “natural relative price” pn , as there almost inevitably will be if there are
asymmetric disturbances to technology and/or preferences. This means that the conditions required for complete price
stability to be fully optimal are even more stringent (and implausible) in a multisector economy. 92 As in Section 3.4.2, a log-
linear approximation to the optimal evolution of the endogenous variables can be obtained by finding the state-contingent
paths of the vari- ables {P1t, P2t, Yt} that minimize Eq. (144) subject to the constraints (143). The FOCs
for this problem can be written as

ojpjt þ ’jt — ’j;t—1 j—1 ¼ 0; ð145Þ

þ ð—1Þ c
lxðxt — xmÞ— Xkj’jt ¼ 0; ð146Þ
lRðpRt — pn Þ— Xgj’jt þ ct — bEtctþ1 ¼ 0;

where Eq. (145) must hold for j ¼ 1, 2. Here ’jt is the Lagrange multiplier associated
with constraint (143) (for j ¼ 1, 2), and ct is the Lagrange multiplier associated with
the identity

p
Rt ¼ pR;t—1 þ p2t — p1t :
The optimal state-contingent dynamics are then obtained by solving the four FOCs
(145) – (147) and the three structural equations ((143) plus the identity) each period for the paths of the seven endogenous
variables {pjt, pRt, xt, ’jt, ct}, given stochastic processes for the composite exogenous disturbances fpn ; ujtg.
Figure 5 illustrates the kind of solution implied by these equations in a numerical example. In this example, the two sectors
are assumed to be of equal size (n1 ¼ n2 ¼ 0.5), but prices in sector 2 are assumed to be more flexible; specifically, while
the over- all frequency of price change is assumed to be the same as in the example considered in Figure 1 (where a ¼ 0.66
for all firms), the model is now parameterized so that prices adjust roughly twice as often in sector 2 as in sector 1 (a1
0.77, a2 0.55). In other
respects, the model is parameterized as in Figure 1. 93 The disturbance assumed is one

that immediately and permanently increases the (log) natural relative price pn
92
It can be shown, however, that even in the presence of asymmetric disturbances to technology and preferences, if the degree of price stickiness
is the same in both sectors (a1 ¼ a2) and there are no cost-push disturbances, it is optimal to completely stabilize an equally weighted price index;
just as in the one-sector model, this policy will completely stabilize the output gap xt. (See Woodford, 2003, Chap. 6, Sec. 4.3.) However, this
result no longer holds if a1 a2.
93
The parameter values assumed for b, z, o, and y, as well as for the average frequency of price adjustment, are taken from Woodford (2003,
Table 5.1). In addition, it is assumed that y ¼ 1, so that the expenditure shares of the two
sectors remain constant over time, despite permanent shifts in the relative price pRt.
 ime of
y rule, the unconditional
onditions (xt0—1 ¼ 0) using the
um implied by the time-
y rule to be chosen simply on
he exogenous dis- turbances),
de. But note that a time-
onsidered, Eq. (6) must be
in the terminology of Rawls
he policy is reconsidered. If one
t of fictitious initial conditions,
o conform to the target criterion
under the fictitious initial

ote that if

ter- native rule (25) depends on

ious) initial conditions. While
e, it has unappealing aspects. In
ifferent in the case of each of
ons for (xt—1, ut), so that a given
ssumed when evaluating that

um (2002) leads to the choice

ously defined) only to the extent
and (25) become identical.)
t is not obvious that the

that the evolution of the

ome class of “simple” rules, under which

Monetary Stabilization Policy 807

evitably will be if there are
quired for complete price
As in Section 3.4.2, a log-
finding the state-contingent
OCs

ð145Þ

associated
ciated with

paths of the seven endogenous

nces fpn ; ujtg.
n this example, the two sectors
e flexible; specifically, while
ed in Figure 1 (where a ¼ 0.66
sector 2 as in sector 1 (a1

of the
preferences, if the degree of price stickiness
ly stabilize an equally weighted price index;
2003, Chap. 6, Sec. 4.3.) However, this

stment, are taken from Woodford (2003,