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Imperfect Knowledge and the Pitfalls of Optimal Control Monetary Policy

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  • Athanasios Orphanides

    ()
    (Central Bank of Cyprus)

  • John C. Williams

    ()
    (Federal Reserve Bank of San Francisco)

Abstract

This paper examines the robustness characteristics of optimal control policies derived under the assumption of rational expectations to alternative models of expectations formation and uncertainty about the natural rates of interest and unemployment. We assume that agents have imperfect knowledge about the precise structure of the economy and form expectations using a forecasting model that they continuously update based on incoming data. We also allow for central bank uncertainty regarding the natural rates of interest and unemployment. We find that the optimal control policy derived under the assumption of perfect knowledge about the structure of the economy can perform poorly when knowledge is imperfect. These problems are exacerbated by natural rate uncertainty, even when the central bank's estimates of natural rates are efficient. We show that the optimal control approach can be made more robust to the presence of imperfect knowledge by deemphasizing the stabilization of real economic activity and interest rates relative to inflation in the central bank loss function. That is, robustness to the presence of imperfect knowledge about the economy provides an incentive to employ a "conservative" central banker. We then examine two types of simple monetary policy rules from the literature that have been found to be robust to model misspecification in other contexts. We find that these policies are robust to the alternative models of learning that we study and natural rate uncertainty and outperform the optimal control policy and generally perform as well as the robust optimal control policy that places less weight on stabilizing economic activity and interest rates.

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File URL: http://www.centralbank.gov.cy/media/pdf/NPWPE_No5_072008_.pdf
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Bibliographic Info

Paper provided by Central Bank of Cyprus in its series Working Papers with number 2008-5.

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Length: 34 pages
Date of creation: Jul 2008
Date of revision:
Handle: RePEc:cyb:wpaper:2008-5

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Web page: http://www.centralbank.gov.cy/nqcontent.cfm?a_id=1
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Keywords: Rational expectations; robust Control; model uncertainty; natural rate of unemployment; natural rate of interest;

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References

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  1. Andrew Levin & Volker Wieland & John Williams, 2000. "The Performance Of Forecast-Based Monetary Policy Rules Under Model Uncertainty," Computing in Economics and Finance 2000 203, Society for Computational Economics.
  2. Athanasios Orphanides & Simon van Norden, 1999. "The reliability of output gap estimates in real time," Finance and Economics Discussion Series 1999-38, Board of Governors of the Federal Reserve System (U.S.).
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  7. Milton Friedman, 1947. "Lerner on the Economics of Control," Journal of Political Economy, University of Chicago Press, vol. 55, pages 405.
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Cited by:
  1. Athanasios Orphanides & John C. Williams, 2012. "Monetary Policy Mistakes and the Evolution of Inflation Expectations," NBER Chapters, in: The Great Inflation: The Rebirth of Modern Central Banking, pages 255-288 National Bureau of Economic Research, Inc.

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