LEO. Svensson/ European Economic Reuiew 46(2002)771-780 between social welfare(utility of the representative consumer)and the frequently used quadratic loss functions representing inflation targeting, and the role of interest-rate stabilization/smoothing. a good part of the research has been on monetary-policy rules, including whether commitment or discretion is the realistic assumption, prop- erties of simple instrument rules, especially Taylor-type rules, and the relation between instrument rules and targeting rules (to be defined). There has been work on mone- tary policy under uncertainty, for instance, on partial information about state of the world, certainty-equivalence, optimal estimation and control; on model uncertainty, Brainard-type multiplicative uncertainty, robust control versus Bayesian control; and on whether uncertainty implies more cautious or more aggressive policy. There has been work on the role of transparency and credibility for successful inflation targeting A research area of enormous practical importance, given the deteriorating economic situation in Japan, concerns avoiding and escaping from liquidity traps and deflation, and handling the zero bound on nominal interest rates. Much recent work has focused explicitly on inflation targeting in open economies, including the choice of the optimal target index the role of the exchange-rate. The pros and cons of inflation targeting in developing economies and transition economies is an increasingly important research area(Amato and Gerlach, 2002) There is no way I can cover this massive amount of work in a short paper. In- tead I will focus on one controversial issue, where I have done some research of my own(especially in Svensson, 2001b), namely how to model inflation targeting: more specifically, what the policy rule is, and whether this policy rule is best seen as instrument rule or a targeting rule. 2 2. How to model inflation targeting? There is by now widespread agreement among central bankers and academics that inflation targeting in practice is"flexible""inflation targeting(see, for instance, several contributions in Federal Reserve Bank of Kansas City (1996, 1999)): The objective is to stabilize inflation around the inflation target, but also to put some weight on stabilizing th potential output (the level of output that would result with flexible prices ) Such an objective can be described by a quadratic intertemporal loss function in period t, =(1-E∑δx+-x2)2+x2+1 where 8(0<8<1)is a discount factor, E, denotes expectations conditional on infor- mation available in period t, I and x denote inflation and the output gap in period t, respectively, T' is the inflation target, and i>0 is the relative weight on output-gap stabilization. Thus, inflation and the output gap are the"target variables", that is, the 2 My presentation at the EEA 2001 Annual Congress also covered the issues of commitment versus discretion in inflation targeting, the relation between inflation targeting and welfare-optimizing policy, and the zero bound for interest rates and liquidity traps. Because of space constraints, these issues are not discussed herL.E.O. Svensson / European Economic Review 46 (2002) 771 – 780 773 between social welfare (utility of the representative consumer) and the frequently used quadratic loss functions representing in ation targeting, and the role of interest-rate stabilization=smoothing. A good part of the research has been on monetary-policy rules, including whether commitment or discretion is the realistic assumption, prop￾erties of simple instrument rules, especially Taylor-type rules, and the relation between instrument rules and targeting rules (to be de@ned). There has been work on mone￾tary policy under uncertainty, for instance, on partial information about state of the world, certainty-equivalence, optimal estimation and control; on model uncertainty, Brainard-type multiplicative uncertainty, robust control versus Bayesian control; and on whether uncertainty implies more cautious or more aggressive policy. There has been work on the role of transparency and credibility for successful in ation targeting. A research area of enormous practical importance, given the deteriorating economic situation in Japan, concerns avoiding and escaping from liquidity traps and de ation, and handling the zero bound on nominal interest rates. Much recent work has focused explicitly on in ation targeting in open economies, including the choice of the optimal target index the role of the exchange-rate. The pros and cons of in ation targeting in developing economies and transition economies is an increasingly important research area (Amato and Gerlach, 2002). There is no way I can cover this massive amount of work in a short paper. In￾stead I will focus on one controversial issue, where I have done some research of my own (especially in Svensson, 2001b), namely how to model in ation targeting: more speci@cally, what the policy rule is, and whether this policy rule is best seen as an instrument rule or a targeting rule. 2 2. How to model ination targeting? There is by now widespread agreement among central bankers and academics that in ation targeting in practice is “ exible” in ation targeting (see, for instance, several contributions in Federal Reserve Bank of Kansas City (1996, 1999)): The objective is to stabilize in ation around the in ation target, but also to put some weight on stabilizing the output gap, the diNerence between actual output and the “natural” output level, potential output (the level of output that would result with exible prices). Such an objective can be described by a quadratic intertemporal loss function in period t, Lt = (1 − )Et
∞ =0  [(t+ − ∗) 2 + x2 t+]; (2.1) where  (0 ¡¡1) is a discount factor, Et denotes expectations conditional on infor￾mation available in period t; t and xt denote in ation and the output gap in period t, respectively, ∗ is the in ation target, and  ¿0 is the relative weight on output-gap stabilization. Thus, in ation and the output gap are the “target variables”, that is, the 2 My presentation at the EEA 2001 Annual Congress also covered the issues of commitment versus discretion in in ation targeting, the relation between in ation targeting and welfare-optimizing policy, and the zero bound for interest rates and liquidity traps. Because of space constraints, these issues are not discussed here