into either shifts in the inflation target or shifts in the perceived target. This approach
contrasts with that in Clarida, Gali, and Gertler (1998), where it is assumed the inflation
target is fixed over a post-1979 sample. They captured structural breaks in the policy
function by estimating two policy functions: one for the period ending in 1979 and one for
the period since 1979. While policy function parameters differed across subsamples, they
were assumed to be constant within each subsample. Clarida, Gali, and Gertler concluded
that the inflation target has been constant, and roughly equal to 4 percent, since 1979.
To assess the implications of possibly shifting targets and imperfect policy credibility on
model dynamics, a comparison model with a constant known target was estimated. This
“constant” model is closer in structure to a typical VAR and includes the four observable
model variables: the output gap, inflation, the federal funds rate, and a long-term interest
rate. However, as in the time-varying target model, the funds rate equation has been
replaced by a Taylor rule with smoothing. Structural shocks to aggregate demand, aggregate
supply, monetary policy, and the term premium are identified using the same causal ordering
as in the model that allowed time variation in the target and perceived target. The
“constant” model was estimated using a generalized version of the seemingly unrelated
regressors methodology to account for cross-equation restrictions and correlations between
equation residuals. Estimates of the coefficients that summarize the structural relationships
between the residuals and estimates of the standard errors of the structural shocks are
obtained using a Cholesky decomposition of the estimated residual covariance matrix.
Estimation results for both the time-varying target model and the constant target
model are provided in Tables 1-3. The model specifications are similar in many ways.
In both models the natural rate of the output gap is insignificantly different from zero, the
equilibrium real rate is close to 3 percent and the term premium natural rate is close to 0.7
percent (Table 1). In addition, estimates of parameters that identify structural shocks (c..)
that are common to the two models, and estimates of standard errors of aggregate demand
16