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Managing uncertainty through robust-satisficing monetary policy

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Abstract

We employ information-gap decision theory to derive a robust monetary policy response to Knightian parameter uncertainty. This approach provides a quantitative answer to the question: For a specified policy, how much can our models and data err or vary, without rendering the outcome of that policy unacceptable to a policymaker? For a given acceptable level of performance, the policymaker selects the policy that delivers acceptable performance under the greatest range of uncertainty. We show that such information-gap robustness is a proxy for probability of policy success. Hence, policies that are likely to succeed can be identified without knowing the probability distribution. We adopt this approach to investigate empirically the robust monetary policy response to a supply shock with an uncertain degree of persistence.

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Bibliographic Info

Paper provided by Norges Bank in its series Working Paper with number 2006/10.

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Length: 33 pages
Date of creation: 23 Oct 2006
Date of revision:
Handle: RePEc:bno:worpap:2006_10

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Keywords: Knightian uncertainty; Monetary policy; Info-gap decision theory.;

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References

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  1. Lars Peter Hansen & Thomas J. Sargent, 2001. "Acknowledging Misspecification in Macroeconomic Theory," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 4(3), pages 519-535, July.
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  3. Andrew Levin & John C. Williams, 2000. "The Performance of Forecast-Based Monetary Policy Rules under Model Uncertainty," Econometric Society World Congress 2000 Contributed Papers 1781, Econometric Society.
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  5. Adam, Klaus, 2004. "On the relation between robust and Bayesian decision making," Journal of Economic Dynamics and Control, Elsevier, vol. 28(10), pages 2105-2117, September.
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  8. S. Zakovic & V. Wieland & B. Rustem, 2004. "Stochastic Optimisation and Worst Case Analysis in Monetary Policy Design," Computing in Economics and Finance 2004 213, Society for Computational Economics.
  9. Hansen, Lars Peter & Maenhout, Pascal & Rustichini, Aldo & Sargent, Thomas J. & Siniscalchi, Marciano M., 2006. "Introduction to model uncertainty and robustness," Journal of Economic Theory, Elsevier, vol. 128(1), pages 1-3, May.
  10. J. Tetlow, Robert & von zur Muehlen, Peter, 2001. "Robust monetary policy with misspecified models: Does model uncertainty always call for attenuated policy?," Journal of Economic Dynamics and Control, Elsevier, vol. 25(6-7), pages 911-949, June.
  11. Larry G. Epstein & JianJun Miao, 2001. "A Two-Person Dynamic Equilibrium under Ambiguity," RCER Working Papers 478, University of Rochester - Center for Economic Research (RCER).
  12. Epstein, Larry G & Wang, Tan, 1994. "Intertemporal Asset Pricing Under Knightian Uncertainty," Econometrica, Econometric Society, vol. 62(2), pages 283-322, March.
  13. Yakov Ben-Haim, 2005. "Value-at-risk with info-gap uncertainty," Journal of Risk Finance, Emerald Group Publishing, vol. 6(5), pages 388-403, November.
  14. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
  15. Q. Farooq Akram & Gunnar Bärdsen & Øyvind Eitrheim, 2006. "Monetary policy and asset prices: to respond or not?," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 11(3), pages 279-292.
  16. Ramón Adalid & Günter Coenen & Peter McAdam & Stefano Siviero, 2005. "The Performance and Robustness of Interest-Rate Rules in Models of the Euro Area," International Journal of Central Banking, International Journal of Central Banking, vol. 1(1), May.
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Cited by:
  1. Ales Bulir & Katerina Smídková, 2008. "Striving to Be "Clearly Open" and "Crystal Clear"," IMF Working Papers 08/84, International Monetary Fund.

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