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Uncertainty about the Persistence of Cost-Push Shocks and the Optimal Reaction of the Monetary Authority

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  • Arnulfo Rodríguez
  • Fidel González
  • Jesús R. González García

Abstract

In this paper we formalize the uncertainty about the persistence of cost-push shocks using an open economy optimal control model with Markov regime-switching and robust control. The latter is used in only one of the regimes producing relatively more persistent cost-push shocks in that regime. Conditional on being in the regime with relatively less persistence, we obtain two main results: a) underestimating the probability of switching to the regime with relatively more persistent cost-push shocks causes higher welfare losses than its overestimation; and b) the welfare losses associated with either underestimation or overestimation of such probability increase with the size of the penalty on inflation deviations from its target. Keywords: Model uncertainty, Robustness, Markov regime-switching, Monetary policy, Inflation targeting.

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File URL: http://www.banxico.org.mx/publicaciones-y-discursos/publicaciones/documentos-de-investigacion/banxico/%7B66932DD9-AD1F-4CA5-126D-505703BE8534%7D.pdf
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Bibliographic Info

Paper provided by Banco de México in its series Working Papers with number 2007-05.

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Date of creation: Mar 2007
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Handle: RePEc:bdm:wpaper:2007-05

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Web page: http://www.banxico.org.mx
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Keywords: Model uncertainty; Robustness; Markov regime-switching; Monetary policy; Inflation targeting;

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Cited by:
  1. Andrew P Blake & Fabrizio Zampolli, 2006. "Optimal monetary policy in Markov-switching models with rational expectations agents," Bank of England working papers 298, Bank of England.

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