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


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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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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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