O Senay, A Sutherland Joumal of International Economic 117(2019)196-208 able 5 General model: LCP Trade elasticity, e Policy rule 0965 0.181 031 0201 0332 Welfare difference 0.003 Portfolio(optimal) 364 53.4 51.3 473 Dev Cpl inflation 0 0048 0.04 St Dev Output gap 0.102 1 0.198 0205 0328 St Dev RER gap 1 Note coefficients. the welfa between optimal policy and inflation targeting, standard deviations and equilibrium portfolios or optimal policy and inflation targeting welfare is measured in terms of the equivalent percentage of steady-state consumption Standard deviations are measured in percentages. Port- holdings are measured relative to stea ady state GDP Table 6 Table 7 shows clearly that it is taste shocks that are particularly im Altemative financial market structures(PCP). portant in generating a hedging conflict. It is only when taste shocks are present(in combination with the other shocks ) that optimal policy gen- erates a significant degree of stabilisation relative to inflation targeting. onds and equities When taste shocks are excluded there is virtually no stabilising effect of Single bond 100 Autarky 099 optimal policy relative to inflation targeting. This indicates that the Note The numbers shown in this table are the ratio of the standard deviation of the rea other five shocks, even though they are uncorrelated with each other. produce effects on asset returns and the marginal utility of consun Imotion exchange rate yielded by optimal policy relative to the standard deviation yielded by infla- that are so similar that the equilibrium portfolio of bonds and equities tion targeting. provides a good hedge for all shocks regardless of the choice of policy rule coefficients. Taste shocks, on the other hand, appear to generate el hedge two different sources of shocks In the case of the simple model fects on asset returns and marginal utility which are very different from his was the trade-off between hedging TFP shocks and taste shocks. the effects of the other shocks, so taste shocks create a hedging conflict The generalised model contains 6 types of shock. It is useful to consider with the other shocks which does not otherwise arise the role of each shock in generating a hedging trade-off. To do this we The results illustrated in Table 7 obviously raises the question: why consider the implications of removing each source of shock in turn do taste shocks play such a significant role? That answer to this is that while retaining the other five). Table 8 shows the stabilising effect of taste shocks, by their very nature, directly impinge on the marginal util ptimal policy(i.e the ratio of the standard deviation of the real ex- ity of consumption. All of the other five shocks only indirectly affect the change rate gap yield by optimal policy relative to inflation targeting). marginal utility of consumption via their effects on household dispos- Here we focus on the PCP case with 0= 1.5. In each column we remove able income. Any portfolio which hedges disposable income fluctua- one shock and retain the other fiv tions will therefore be a reasonably good hedge against all the other Table 7 g shocks. Omitted shock(s) Labour Tast Mark-up Policy rule 0.129 0.129 0026 1.349 0565 0977 0016 0986 Welfare difference 00034 0.0039 0.0000 Portfolio(optimal) 13 St Dev ppi inflation 0.0055 St Dev Output 0095 St Dev re ote Each c me when one type of shock is omitted. Each column shows the optimal policy rule coefficients, the welfare difference between optimal policy and inflation targeting, standard deviations and equilibrium portfolios for optimal policy and inflation targeting. Welfare is measured in terms of the equivalent percentage of teady-state consumption. Standard deviations are measured in percentages. Portfolio holdings are measured relative to steady state GDP.hedge two different sources of shocks. In the case of the simple model this was the trade-off between hedging TFP shocks and taste shocks. The generalised model contains 6 types of shock. It is useful to consider the role of each shock in generating a hedging trade-off. To do this we consider the implications of removing each source of shock in turn (while retaining the other five). Table 8 shows the stabilising effect of optimal policy (i.e. the ratio of the standard deviation of the real ex￾change rate gap yield by optimal policy relative to inflation targeting). Here we focus on the PCP case with θ = 1.5. In each column we remove one shock and retain the other five. Table 7 shows clearly that it is taste shocks that are particularly im￾portant in generating a hedging conflict. It is only when taste shocks are present (in combination with the other shocks) that optimal policy gen￾erates a significant degree of stabilisation relative to inflation targeting. When taste shocks are excluded there is virtually no stabilising effect of optimal policy relative to inflation targeting. This indicates that the other five shocks, even though they are uncorrelated with each other, produce effects on asset returns and the marginal utility of consumption that are so similar that the equilibrium portfolio of bonds and equities provides a good hedge for all shocks regardless of the choice of policy rule coefficients. Taste shocks, on the other hand, appear to generate ef￾fects on asset returns and marginal utility which are very different from the effects of the other shocks, so taste shocks create a hedging conflict with the other shocks which does not otherwise arise. The results illustrated in Table 7 obviously raises the question: why do taste shocks play such a significant role? That answer to this is that taste shocks, by their very nature, directly impinge on the marginal util￾ity of consumption. All of the other five shocks only indirectly affect the marginal utility of consumption via their effects on household dispos￾able income. Any portfolio which hedges disposable income fluctua￾tions will therefore be a reasonably good hedge against all the other Table 6 Alternative financial market structures (PCP). Trade elasticity, θ 0.25 0.5 0.75 1.5 3 Bonds and equities 0.70 0.64 0.59 0.48 0.36 Single bond 0.98 0.87 1.00 1.00 1.00 Autarky 0.99 0.93 0.99 1.00 1.00 Note: The numbers shown in this table are the ratio of the standard deviation of the real exchange rate yielded by optimal policy relative to the standard deviation yielded by infla￾tion targeting. Table 5 General model: LCP. Trade elasticity, θ 0.25 0.5 0.75 1.5 3 Policy rule δY 0.136 2.025 0.188 0.138 0.127 δτ −0.965 −0.181 −0.316 −0.299 −0.201 δD −0.143 −1.829 −2.029 −1.099 −1.626 δℒ 1.912 0.358 0.535 0.452 0.262 δπ 0.311 0.334 0.352 0.332 0.334 Welfare difference 0.0026 0.0029 0.0031 0.0034 0.0037 Portfolio (optimal) ðbondsÞ ðequitiesÞ 45:2 −54:7 36:4 −42:0 23:2 −20:4 41:3 −24:3 66:0 −72:3 (inf tar) ðbondsÞ ðequitiesÞ 28:9 −53:4 29:7 −51:3 29:8 −47:3 32:9 −25:2 49:3 −64:2 St Dev CPI Inflation (optimal) 0.053 0.048 0.043 0.029 0.020 St Dev Output gap (optimal) 0.037 0.102 0.145 0.208 0.240 (inf tar) 0.076 0.148 0.198 0.275 0.328 St Dev RER gap (optimal) 2.81 2.02 1.68 1.43 1.40 (inf tar) 3.67 2.69 2.20 1.65 1.42 Note: For each θ the table shows the optimal policy rule coefficients, the welfare difference between optimal policy and inflation targeting, standard deviations and equilibrium portfolios for optimal policy and inflation targeting. Welfare is measured in terms of the equivalent percentage of steady-state consumption. Standard deviations are measured in percentages. Port￾folio holdings are measured relative to steady state GDP. Table 7 Omitting shocks. Omitted shock(s) TFPþ News Gov spending Labour supply Taste Mark-up Policy rule δY 0.129 0.129 0.129 0.129 0.000 δτ −0.013 −0.026 −0.049 0.001 0.000 δD −1.349 −0.565 0.977 −0.016 −0.986 δℒ 00 000 δπ 0.998 1.000 0.996 0.999 0.997 Welfare difference 0.0034 0.0039 0.0038 0.0000 0.0038 Portfolio (optimal) ðbondsÞ ðequitiesÞ 28:4 −4:7 19:3 16:0 11:8 33:1 21:6 0:1 23:1 7:4 (inf tar) ðbondsÞ ðequitiesÞ 17:3 3:9 21:2 0:1 21:1 0:3 21:5 0:0 21:1 0:4 St Dev PPI Inflation (optimal) 0.0060 0.0055 0.0084 0.0031 0.0063 St Dev Output gap (optimal) 0.042 0.095 0.093 0.089 0.093 (inf tar) 0.167 0.196 0.195 0.092 0.194 St Dev RER gap (optimal) 0.26 0.63 0.62 0.60 0.63 (inf tar) 1.12 1.32 1.32 0.60 1.32 Note: Each column in this table shows the outcome when one type of shock is omitted. Each column shows the optimal policy rule coefficients, the welfare difference between optimal policy and inflation targeting, standard deviations and equilibrium portfolios for optimal policy and inflation targeting. Welfare is measured in terms of the equivalent percentage of steady-state consumption. Standard deviations are measured in percentages. Portfolio holdings are measured relative to steady state GDP. 206 O. Senay, A. Sutherland / Journal of International Economics 117 (2019) 196–208