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Avoiding Nash inflation: Bayesian and robust responses to model uncertainty

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Author Info
Robert J. Tetlow
Peter von zur Muehlen

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Abstract

In his 1999 monograph The Conquest of American Inflation Tom Sargent describes how a policymaker, who applies a constant-gain algorithm in estimating the Phillips curve, can fall into the grip of an induction problem: concluding on the basis of reduced-form evidence that the trade-off between inflation and output is more favorable than it actually is. This results in oscillations between periods of disinflation and reflation. The problem arises because the policymaker is naive about possible misspecification, her role in creating that misspecification, and its role in policy design. In particular, while her use of a constant-gain algorithm admits the possibility that her model may be misspecified, she does not take this into consideration when designing policy. In this paper, we relax this assumption. We derive five policy rules which treat possible misspecification in three different ways. First, the linear-quadratic Gaussian (LQG) rule exhibits the familiar pattern of escape dynamics described by Sargent. We show a rule that takes uncertainty seriously, but in a Bayesian fashion, does no better. Finally, we consider three rules that are robust in the sense of Knight. The robust rules do a worse job than the LQG approach, and sometimes a lot worse. This is so even though the induction problem faced by the policymaker provides a prima facie case for being robust. We conclude that there appears to be no obvious tool that can be applied mechanically to alleviate the induction problem. A corollary of this finding is that Sargent's story for the inflation of the 1970s is robust to relaxing a key assumption in the original monograph.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2002-9.

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Date of creation: 2002
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Handle: RePEc:fip:fedgfe:2002-9

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Keywords: Inflation (Finance) ; Econometric models;

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  34. Tetlow, Robert J. & von zur Muehlen, Peter, 2001. "Simplicity versus optimality: The choice of monetary policy rules when agents must learn," Journal of Economic Dynamics and Control, Elsevier, vol. 25(1-2), pages 245-279, January. [Downloadable!] (restricted)
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  39. Simon Hall & Chris Salmon & Tony Yates & Nicoletta Batini, . "Uncertainty and Simple Monetary Policy Rules - An illustration for the United Kingdom," Bank of England working papers 96, Bank of England. [Downloadable!]
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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Robert J. Tetlow & Peter von zur Muehlen, 2005. "Robustifying learnability," Finance and Economics Discussion Series 2005-58, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  2. Andrew T. Levin & Alexei Onatski & John C. Williams & Noah Williams, 2005. "Monetary policy under uncertainty in micro-founded macroeconometric models," Working Papers in Applied Economic Theory 2005-15, Federal Reserve Bank of San Francisco. [Downloadable!]
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  3. Fidel Gonzalez & Arnulfo Rodriguez, 2004. "Robust Control: A Note on the Response of the Control to Changes in the “Free” Parameter Conditional on the Character of Nature," Computational Economics, Springer, vol. 24(3), pages 223-238, March. [Downloadable!] (restricted)
  4. Küster, Keith & Wieland, Volker, 2005. "Insurance Policies for Monetary Policy in the Euro Area," CEPR Discussion Papers 4956, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  5. Thomas Sargent & Noah Williams & Tao Zha, 2006. "The conquest of South American inflation," Working Paper 2006-20, Federal Reserve Bank of Atlanta. [Downloadable!]
    Other versions:
  6. Martin Ellison & Liam Graham & Jouka Vilmunen, 2005. "Strong Contagion with Weak Spillovers," Money Macro and Finance (MMF) Research Group Conference 2005 91, Money Macro and Finance Research Group. [Downloadable!]
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  7. Meixing DAI & Eleftherios SPYROMITROS, 2008. "Monetary policy, asset prices and model uncertainty," Working Papers of BETA 2008-15, Bureau d'Economie Théorique et Appliquée, ULP, Strasbourg. [Downloadable!]
  8. Fabrizio Zampolli, . "Optimal monetary policy in a regime-switching economy: the response to abrupt shifts in exchange rate dynamics," Bank of England working papers 297, Bank of England. [Downloadable!]
  9. Robert J. Tetlow & Brian Ironside, 2006. "Real-time model uncertainty in the United States - the Fed from 1996-2003," Working Paper Series 610, European Central Bank. [Downloadable!]
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  10. Gonzalez F. & Rodriguez A. & Gonzalez-Garcia J.R., 2005. "Uncertainty about the Persistence of Periods with Large Price Shocks and the Optimal Reaction of the Monetary Authority," Computing in Economics and Finance 2005 402, Society for Computational Economics. [Downloadable!]
  11. David Kendrick & Hans Amman, 2006. "A Classification System for Economic Stochastic Control Models," Computational Economics, Springer, vol. 27(4), pages 453-481, June. [Downloadable!] (restricted)
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