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Caution and gradualism in monetary policy under uncertainty

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  • Ben Martin
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    Abstract

    This paper explores the theoretical implication of parameter uncertainty for the optimal monetary policy reaction function. The policy-maker sets the nominal interest rate to meet an inflation target in a simple dynamic model of the economy. The paper looks at how parameter uncertainty in the transmission mechanism affects the optimal nominal and real interest rate relative to the case when the parameters are known. Its chief contribution is to show that three consequences are identified: conservatism (smaller deviations of real and nominal interest rates from some neutral level in response to inflationary shocks), gradualism (increased autocorrelation in real and nominal interest rates) and caution (a smaller cumulative policy response). The paper examines the sensitivity of these effects to different specifications of the transmission mechanism; in particular the introduction of an exchange rate channel. The paper also considers situations in which a more aggressive response may be called for.

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    File URL: http://www.bankofengland.co.uk/archive/Documents/historicpubs/workingpapers/1999/wp105.pdf
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    Bibliographic Info

    Paper provided by Bank of England in its series Bank of England working papers with number 105.

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    Date of creation: Dec 1999
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    Handle: RePEc:boe:boeewp:105

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    References

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    1. Goodfriend, Marvin, 1991. "Interest rates and the conduct of monetary policy," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 34(1), pages 7-30, January.
    2. Alexei Onatski & James H. Stock, 1999. "Robust monetary policy under model uncertainty in a small model of the U.S. economy," Proceedings, Federal Reserve Bank of San Francisco.
    3. Svensson, L-E-O, 1997. "Inflation Targeting : Some Extensions," Papers 625, Stockholm - International Economic Studies.
    4. Brian Sack, 1998. "Does the Fed act gradually? a VAR analysis," Finance and Economics Discussion Series 1998-17, Board of Governors of the Federal Reserve System (U.S.).
    5. Turnovsky,Stephen J., 1977. "Macroeconomic Analysis and Stabilization Policy," Cambridge Books, Cambridge University Press, number 9780521291873, October.
    6. Svensson, Lars E O, 1996. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," CEPR Discussion Papers 1511, C.E.P.R. Discussion Papers.
    7. Geoffrey Shuetrim & Christopher Thompson, 1999. "The Implications of Uncertainty for Monetary Policy," RBA Research Discussion Papers rdp1999-10, Reserve Bank of Australia.
    8. Svensson, Lars E. O., 2000. "Open-economy inflation targeting," Journal of International Economics, Elsevier, vol. 50(1), pages 155-183, February.
    9. Woodford, Michael, 1999. "Optimal monetary policy inertia," CFS Working Paper Series 1999/09, Center for Financial Studies (CFS).
    10. Michael Woodford, 1999. "Optimal monetary policy inertia," Proceedings, Federal Reserve Bank of San Francisco.
    11. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
    12. Rudebusch, Glenn D & Svensson, Lars E O, 1998. "Policy Rules for Inflation Targeting," CEPR Discussion Papers 1999, C.E.P.R. Discussion Papers.
    13. Stephen G. Cecchetti, 1998. "Policy rules and targets: framing the central banker's problem," Economic Policy Review, Federal Reserve Bank of New York, issue Jun, pages 1-14.
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    Cited by:
    1. Ben Martin & Chris Salmon, 1999. "Should uncertain monetary policy-makers do less?," Bank of England working papers 99, Bank of England.
    2. Olalla, Myriam García & Gómez, Alejandro Ruiz, 2011. "Robust control and central banking behaviour," Economic Modelling, Elsevier, vol. 28(3), pages 1265-1278, May.
    3. Chen, Shu-hua & Shaw, Ming-fu & Lai, Ching-chong & Chang, Juin-jen, 2008. "Interest-rate rules and transitional dynamics in an endogenously growing open economy," Journal of International Money and Finance, Elsevier, vol. 27(1), pages 54-75, February.
    4. Marc-Alexandre Sénégas, 2002. "La politique monétaire face à l'incertitude : un survol méthodologique des contributions relatives à la zone euro," Revue d'Économie Financière, Programme National Persée, vol. 65(1), pages 177-200.

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