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Simple versus optimal rules as guides to policy

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Author Info

  • Brock, William A.
  • Durlauf, Steven N.
  • Nason, James M.
  • Rondina, Giacomo

Abstract

This paper contributes to the policy evaluation literature by developing new strategies to study alternative policy rules. We compare optimal rules to simple rules within canonical monetary policy models. In our context, an optimal rule represents the solution to an intertemporal optimization problem in which a loss function for the policymaker and an explicit model of the macroeconomy are specified. We define a simple rule to be a summary of the intuition policymakers and economists have about how a central bank should react to aggregate disturbances. The policy rules are evaluated under minimax and minimax regret criteria. These criteria force the policymaker to guard against a worst-case scenario, but in different ways. Minimax makes the worst possible model the benchmark for the policymaker, while minimax regret confronts the policymaker with uncertainty about the true model. Our results indicate that the case for a model-specific optimal rule can break down when uncertainty exists about which of several models is true. Further, we show that the assumption that the policymaker’s loss function is known can obscure policy trade-offs that exist in the short, medium, and long run. Thus, policy evaluation is more difficult once it is recognized that model and preference uncertainty can interact.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Monetary Economics.

Volume (Year): 54 (2007)
Issue (Month): 5 (July)
Pages: 1372-1396

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Handle: RePEc:eee:moneco:v:54:y:2007:i:5:p:1372-1396

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Web page: http://www.elsevier.com/locate/inca/505566

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References

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  1. William A. Brock & Steven N. Durlauf, 2004. "Elements of a Theory of Design Limits to Optimal Policy," NBER Working Papers 10495, National Bureau of Economic Research, Inc.
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  6. Alexei Onatski & Noah Williams, 2002. "Modeling model uncertainty," Discussion Papers 0203-05, Columbia University, Department of Economics.
  7. William A. Brock & Steven N. Durlauf & Giacomo Rondina, 2008. "Design Limits and Dynamic Policy Analysis," NBER Working Papers 14357, National Bureau of Economic Research, Inc.
  8. Chamberlain, Gary, 2000. "Econometrics and decision theory," Journal of Econometrics, Elsevier, vol. 95(2), pages 255-283, April.
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  17. Jörg Stoye, 2011. "Statistical decisions under ambiguity," Theory and Decision, Springer, vol. 70(2), pages 129-148, February.
  18. William A. Brock, 2006. "Profiling Problems With Partially Identified Structure," Economic Journal, Royal Economic Society, vol. 116(515), pages F427-F440, November.
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  20. Alan S. Blinder, 1999. "Central Banking in Theory and Practice," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262522608, December.
  21. Brock, William A. & Durlauf, Steven N. & West, Kenneth D., 2007. "Model uncertainty and policy evaluation: Some theory and empirics," Journal of Econometrics, Elsevier, vol. 136(2), pages 629-664, February.
  22. McCallum, Bennett T., 1999. "Issues in the design of monetary policy rules," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 23, pages 1483-1530 Elsevier.
  23. Charles F. Manski, 2006. "Search Profiling With Partial Knowledge of Deterrence," Economic Journal, Royal Economic Society, vol. 116(515), pages F385-F401, November.
  24. Jeremy Rudd & Karl Whelan, 2001. "New tests of the New-Keynesian Phillips curve," Finance and Economics Discussion Series 2001-30, Board of Governors of the Federal Reserve System (U.S.).
  25. Brock,W.A. & Durlauf,S.N., 2004. "Local robustness analysis : theory and application," Working papers 22, Wisconsin Madison - Social Systems.
  26. Hansen, Lars Peter & Sargent, Thomas J., 2003. "Robust control of forward-looking models," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 581-604, April.
  27. Otrok, Christopher, 2001. "Spectral Welfare Cost Functions," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 42(2), pages 345-67, May.
  28. Manski, Charles F., 2007. "Minimax-regret treatment choice with missing outcome data," Journal of Econometrics, Elsevier, vol. 139(1), pages 105-115, July.
  29. Tobin, James, 1983. "Monetary Policy: Rules, Targets, and Shocks," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 15(4), pages 506-18, November.
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