Svensson and Woodford abstract

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Lars E.O. Svensson
Princeton University,
Michael Woodford
Columbia University and NBER

First Draft: January 1999
This Version: June 2002

Journal of Economic Dynamics and Control 28 (2004)


The optimal weights on indicators in models with partial information about the state of the economy and forward-looking variables are derived and interpreted, both for equilibria under discretion and under commitment. The private sector is assumed to have more information about the state of the economy than the policymaker. Certainty equivalence holds for the optimal reaction function in state-space form: the coefficients are independent of the degree of uncertainty about the state of the economy. However, in the case of commitment, certainty equivalence does not hold for the reaction function in integrative form: the policy instrument cannot be written as a distributed lag of past estimates of past states of the economy. Instead, optimal policy will generally depend on new estimates of past states of the economy, and in ways that depend on the information structure. Furthermore, the usual separation principle does not hold, since the estimation of the state of the economy is not independent of optimization and is, in general, quite complex. We present a general characterization of optimal filtering and control in settings of this kind, and discuss an application of our methods to the problem of the optimal use of “real-time” macroeconomic data in the conduct of monetary policy.

JEL Classification: E37, E47, E52, E58

Keywords: Partial information, Kalman filter, monetary policy, discretion and
commitment, certainty equivalence, separation principle.