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Imperfect knowledge and the pitfalls of optimal control monetary policy

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  • Athanasios Orphanides
  • John C. Williams

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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Bibliographic Info

Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 2008-09.

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Date of creation: 2008
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Handle: RePEc:fip:fedfwp:2008-09

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Keywords: Rational expectations (Economic theory) ; Monetary policy ; Econometric models;

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  1. John C. Williams, 1999. "Simple rules for monetary policy," Finance and Economics Discussion Series 1999-12, Board of Governors of the Federal Reserve System (U.S.).
  2. Taylor, John B., 1999. "The robustness and efficiency of monetary policy rules as guidelines for interest rate setting by the European central bank," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 655-679, June.
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  7. Athanasios Orphanides & John C. Williams, 2003. "Imperfect Knowledge, Inflation Expectations, and Monetary Policy," NBER Working Papers 9884, National Bureau of Economic Research, Inc.
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  9. Cukierman, Alex & Lippi, Francesco, 2003. "Endogenous Monetary Policy with Unobserved Potential Output," CEPR Discussion Papers 3763, C.E.P.R. Discussion Papers.
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  26. Thomas Laubach, 1997. "Measuring the NAIRU : evidence from seven economies," Research Working Paper 97-13, Federal Reserve Bank of Kansas City.
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Cited by:
  1. Athanasios Orphanides & John C. Williams, 2010. "Monetary policy mistakes and the evolution of inflation expectations," Working Paper Series 2010-12, Federal Reserve Bank of San Francisco.

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