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Uncertainty and the open economy: a view through two different lenses

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Author Info
Kirdan Lees
Abstract

Under a Bayesian framework of model uncertainty, closed economy models of monetary policy typically suggest that policy responses should be attenuated. Conversely, under a Knightian view of uncertainty, where the policymaker cannot specify probabilities across alternative models, intensifying the policy response is recommended. In this paper, this dichotomy is found to extend to the case of a calibrated open economy new-Keynesian model. Two alternative model specifications are developed to examine the influence of the specification of the exchange rate on policy recommendations. One model specifies that the policymaker cares about the volatility of the exchange rate; a second model specifies a small exchange-rate channel relative to the standard channel of transmission. Although these alternative models produce quantitatively different results, qualitatively the models recommend standard results: policy attenuation if the policymaker maintains a Bayesian view of uncertainty and a more aggressive policy response, if the policymaker holds a Knightian view. Ultimately, resolving these policy proscriptions requires addressing the underlying beliefs about uncertainty of the policymaker, rather than the form of the underlying model.

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Paper provided by Econometric Society in its series Econometric Society 2004 Australasian Meetings with number 235.

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Date of creation: 11 Aug 2004
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Handle: RePEc:ecm:ausm04:235

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Related research
Keywords: Uncertainty; Open economy; Bayesian; robust control;

Find related papers by JEL classification:
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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