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Robust monetary policy with competing reference models

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  • Andrew T. Levin
  • John C. Williams

Abstract

The literature on robust monetary policy rules has largely focused on the case in which the policymaker has a single reference model while the true economy lies within a specified neighborhood of the reference model. In this paper, we show that such rules may perform very poorly in the more general case in which non-nested models represent competing perspectives about controversial issues such as expectations formation and inflation persistence. Using Bayesian and minimax strategies, we then consider whether any simple rule can provide robust performance across such divergent representations of the economy. We find that a robust outcome is attainable only in cases where the objective function places substantial weight on stabilizing both output and inflation; in contrast, we are unable to find a robust policy rule when the sole policy objective is to stabilize inflation. We analyze these results using a new diagnostic approach, namely, by quantifying the fault tolerance of each model economy with respect to deviations from optimal policy.

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Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2003-10.

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Date of creation: 2003
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Handle: RePEc:fip:fedfwp:2003-10

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Keywords: Monetary policy ; Econometric models ; Inflation (Finance);

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