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Avoiding Nash Inflation: Bayesian and Robus Responses to Model Uncertainty

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Author Info
Robert Tetlow (Federal Reserve Board)
Peter von zur Muehlen (Federal Reserve Board)

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Abstract

We examine learning, model misspecification, and robust policy responses to misspecification in a quasi-real-time environment. The laboratory for the analysis is the Sargent (1999) explanation for the origins of inflation in the 1970's and the subsequent disinflation. Three robust policy rules are derived that differ according to the extent that misspecification is taken as a parametric phenomenon. These responses to drifting estimated parameters and apparent misspecification are compared to the certainty-equivalent case studied by Sargent. We find gains from utilizing robust approaches to monetary policy design, but only when the approach to robustness is carefully tailored to the problem at hand. In the least parametric approach, the medicine of robust control turns out to be too potent for the disease of misspecification. In the most parametric approach, the response to misspecification is too weak and too misdirected to be of help. But when the robust approach to policy is narrowly directed in the correct location, it can avoid Nash inflation and improve social welfare. It follows that agnosticism regarding the sources of misspecification has its pitfalls. We also find that Sargent's story for the rise of inflation of the 1970s and its subsequent decline in the 1980s is robust to most ways of relaxing a strong assumption in the original work. (Copyright: Elsevier)

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File URL: http://dx.doi.org/10.1016/j.red.2004.06.001
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Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

Volume (Year): 7 (2004)
Issue (Month): 4 (October)
Pages: 869-899
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Handle: RePEc:red:issued:v:7:y:2004:i:4:p:869-899

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Related research
Keywords: Uncertainty; Knightian uncertainty; robust control; learning; monetary policy;

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Find related papers by JEL classification:
C6 - Mathematical and Quantitative Methods - - Mathematical Methods and Programming
C8 - Mathematical and Quantitative Methods - - Data Collection and Data Estimation Methodology; Computer Programs

References listed on IDEAS
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Andrew T. Levin & Alexei Onatski & John C. Williams & Noah Williams, 2005. "Monetary Policy Under Uncertainty in Micro-Founded Macroeconometric Models," NBER Working Papers 11523, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  2. Küster, Keith & Wieland, Volker, 2005. "Insurance Policies for Monetary Policy in the Euro Area," CEPR Discussion Papers 4956, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  3. Thomas Sargent & Noah Williams & Tao Zha, 2006. "The conquest of South American inflation," Working Paper 2006-20, Federal Reserve Bank of Atlanta. [Downloadable!]
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  4. Gonzalez F. & Rodriguez A. & Gonzalez-Garcia J.R., 2005. "Uncertainty about the Persistence of Periods with Large Price Shocks and the Optimal Reaction of the Monetary Authority," Computing in Economics and Finance 2005 402, Society for Computational Economics. [Downloadable!]
  5. Fidel Gonzalez & Arnulfo Rodriguez, 2004. "Robust Control: A Note on the Response of the Control to Changes in the “Free” Parameter Conditional on the Character of Nature," Computational Economics, Springer, vol. 24(3), pages 223-238, March. [Downloadable!] (restricted)
  6. Martin Ellison & Liam Graham & Jouko Vilmunen, 2006. "Strong Contagion with Weak Spillovers," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 9(2), pages 263-283, April. [Downloadable!] (restricted)
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  7. Robert J. Tetlow & Peter von zur Muehlen, 2005. "Robustifying learnability," Finance and Economics Discussion Series 2005-58, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  8. Meixing DAI & Eleftherios SPYROMITROS, 2008. "Monetary policy, asset prices and model uncertainty," Working Papers of BETA 2008-15, Bureau d'Economie Théorique et Appliquée, ULP, Strasbourg. [Downloadable!]
  9. David Kendrick & Hans Amman, 2006. "A Classification System for Economic Stochastic Control Models," Computational Economics, Springer, vol. 27(4), pages 453-481, June. [Downloadable!] (restricted)
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  10. Fabrizio Zampolli, . "Optimal monetary policy in a regime-switching economy: the response to abrupt shifts in exchange rate dynamics," Bank of England working papers 297, Bank of England. [Downloadable!]
  11. Robert J. Tetlow & Brian Ironside, 2006. "Real-time model uncertainty in the United States - the Fed from 1996-2003," Working Paper Series 610, European Central Bank. [Downloadable!]
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