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How robustness can lower the cost of discretion

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  • Dennis, Richard

Abstract

Model uncertainty has the potential to change importantly how monetary policy is conducted, making it an issue that central banks cannot ignore. Using a standard new Keynesian business cycle model, this paper analyzes the behavior of a central bank that conducts policy under discretion while fearing that its model is misspecified. The main results are as follows. First, policy performance can be improved if the discretionary central bank implements a robust policy. This important result is obtained because the central bank's desire for robustness directs it to assertively stabilize inflation, thereby mitigating the stabilization bias associated with discretionary policymaking. Second, the central bank's fear of model misspecification leads it to forecast future outcomes under the belief that inflation (in particular) will be persistent and have large unconditional variance, raising the probability of extreme outcomes. Private agents, however, anticipating the policy response, make decisions under the belief that inflation will be more closely stabilized, that is, more tightly distributed, than under rational expectations. Finally, as a technical contribution, the paper shows how to solve with robustness an important class of linear-quadratic decision problems.

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Bibliographic Info

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

Volume (Year): 57 (2010)
Issue (Month): 6 (September)
Pages: 653-667

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Handle: RePEc:eee:moneco:v:57:y:2010:i:6:p:653-667

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

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Citations

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Cited by:
  1. Richard Dennis, 2012. "Imperfect Credibility and Robust Monetary Policy," CAMA Working Papers 2012-41, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  2. Yulei Luo & Jun Nie & Eric R. Young, 2012. "Model uncertainty and intertemporal tax smoothing," Research Working Paper RWP 12-01, Federal Reserve Bank of Kansas City.
  3. Robert Baumann & Justin Svec, 2013. "The Impact of Political Uncertainty: A Robust Control Approach," Working Papers 1306, College of the Holy Cross, Department of Economics.
  4. Tillmann, Peter, 2012. "Cross-checking optimal monetary policy with information from the Taylor rule," Economics Letters, Elsevier, vol. 117(1), pages 204-207.
  5. Konstantinos Angelopoulos & George Economides & Apostolis Philippopoulos, 2012. "Public Good Provision with Robust Decision Making," CESifo Working Paper Series 3996, CESifo Group Munich.
  6. Ryan Chahrour & Justin Svec, 2014. "Optimal Capital Taxation and Consumer Uncertainty," Boston College Working Papers in Economics 854, Boston College Department of Economics.
  7. Konstantinos Angelopoulos & Jim Malley, 2010. "Fear of Model Misspecification and the Robustness Premium," CESifo Working Paper Series 3186, CESifo Group Munich.
  8. Justin Svec, 2010. "Optimal Fiscal Policy with Robust Control," Working Papers 1004, College of the Holy Cross, Department of Economics.
  9. Olalla, Myriam García & Gómez, Alejandro Ruiz, 2011. "Robust control and central banking behaviour," Economic Modelling, Elsevier, vol. 28(3), pages 1265-1278, May.
  10. Marco M. Sorge, 2012. "Robust Delegation with Uncertain Monetary Policy Preferences," EERI Research Paper Series EERI_RP_2012_05, Economics and Econometrics Research Institute (EERI), Brussels.
  11. Young, Eric R., 2012. "Robust policymaking in the face of sudden stops," Journal of Monetary Economics, Elsevier, vol. 59(5), pages 512-527.

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