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Signal Extraction And Non-Certainty-Equivalence In Optimal Monetary Policy Rules

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SWANSON, ERIC T.

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Abstract

A standard result in the literature on monetary policy rules is that of certainty-equivalence: Given the expected values of the state variables of the economy, policy should be independent of all higher moments of those variables. Some exceptions to this rule have been pointed out in the literature, including restricting the policy response to a limited subset of state variables, or to estimates of the state variables that are biased. In contrast, this paper studies fully optimal policy rules with optimal estimation of state variables. The rules in this framework exhibit certainty-equivalence with respect to estimates of an unobserved state variable ( excess demand ) X, but are not certainty-equivalent when (i) X must be estimated by signal extraction and (ii) the optimal rule is expressed as a reduced form that combines policymakers estimation and policy-setting stages. I find that it is optimal for policymakers to attenuate their reaction to a variable about which uncertainty has increased, while responding more aggressively to variables about which uncertainty has not changed.

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Publisher Info
Article provided by Cambridge University Press in its journal Macroeconomic Dynamics.

Volume (Year): 8 (2004)
Issue (Month): 01 (February)
Pages: 27-50
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Handle: RePEc:cup:macdyn:v:8:y:2004:i:01:p:27-50_02

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  1. Christopher Martin & Costas Milas, 2005. "Uncertainty and Monetary Policy Rules in the United States," Keele Economics Research Papers KERP 2005/10, Centre for Economic Research, Keele University. [Downloadable!]
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  2. Christopher Martin & Costas Milas, 2005. "Uncertainty and UK Monetary Policy," Keele Economics Research Papers KERP 2005/11, Centre for Economic Research, Keele University. [Downloadable!]
    Other versions:
  3. Paul Hubert, 2009. "An Empirical Review of Federal Reserve’s Informational Advantage," Documents de Travail de l'OFCE 2009-03, Observatoire Francais des Conjonctures Economiques (OFCE). [Downloadable!]
  4. Fabrizio Zampolli & Andrew Blake, 2005. "Time Consistent Policy in Markov Switching Models," Money Macro and Finance (MMF) Research Group Conference 2005 2, Money Macro and Finance Research Group. [Downloadable!]
    Other versions:
  5. Andrés González Gómez & Lavan Mahadeva & Diego Rodríguez & Luis Eduardo Rojas, . "Monetary Policy Forecasting in a DSGE Model with Data that is Uncertain, Unbalanced and About the Future," Borradores de Economia 559, Banco de la Republica de Colombia. [Downloadable!]
    Other versions:
  6. Eric T. Swanson, 2005. "Optimal nonlinear policy: signal extraction with a non-normal prior," Working Paper Series 2005-24, Federal Reserve Bank of San Francisco. [Downloadable!]
    Other versions:
  7. Robert Tchaidze & Alina Carare, 2004. "The Use and Abuse of Taylor Rules: How precisely can we estimate them?," Econometric Society 2004 Latin American Meetings 132, Econometric Society. [Downloadable!]
    Other versions:
  8. Christopher Martin & Costas Milas, 2006. "The Impact of Uncertainty on Monetary Policy Rules in the UK," Keele Economics Research Papers KERP 2006/09, Centre for Economic Research, Keele University. [Downloadable!]
  9. Lavan Mahadeva & Alex Muscatelli, 2005. "National Accounts Revisions and Output Gap Estimates in a Model of Monetary Policy with Data Uncertainty," Discussion Papers 14, Monetary Policy Committee Unit, Bank of England. [Downloadable!]
  10. Andrew P Blake & Fabrizio Zampolli, . "Optimal monetary policy in Markov-switching models with rational expectations agents," Bank of England working papers 298, Bank of England. [Downloadable!]
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