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Optimal monetary policy in a micro-founded model with parameter uncertainty

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Author Info
Takeshi Kimura
Takushi Kurozumi

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Abstract

In this paper, we structurally model uncertainty with a micro-founded model, and investigate its implications for optimal monetary policy. Uncertainty about deep parameters of the model implies that the central bank simultaneously faces both uncertainty about the structural dynamic equations and about the social loss function. Considering both uncertainties with cross-parameter restrictions based on the micro-foundations of the model, we use Bayesian methods to determine the optimal monetary policy that minimizes the expected loss. Our analysis shows how uncertainty can lead the central bank to pursue a more aggressive monetary policy, overturning Brainard's common wisdom. As the degree of uncertainty about inflation dynamics increases, the central bank should place much more weight on price stability, and should respond to shocks more aggressively. In addition, when the central bank is uncertain about output dynamics, an aggressive policy response can be justified by the positive correlation between policy multiplier and transmission of natural rate of interest shock as well as the effect of loss-function uncertainty. We also show that combining a more aggressive policy response with a highly inertial interest rate policy reduces Bayesian risk.

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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 2003-67.

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Date of creation: 2003
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Handle: RePEc:fip:fedgfe:2003-67

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Keywords: Monetary policy ; Econometric models;

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  7. Arturo Estrella & Frederic S. Mishkin, 1999. "Rethinking the Role of NAIRU in Monetary Policy: Implications of Model Formulation and Uncertainty," NBER Chapters, in: Monetary Policy Rules, pages 405-436 National Bureau of Economic Research, Inc. [Downloadable!]
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  22. Glenn D. Rudebusch, 2002. "Assessing Nominal Income Rules for Monetary Policy with Model and Data Uncertainty," Economic Journal, Royal Economic Society, vol. 112(479), pages 402-432, April. [Downloadable!] (restricted)
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  23. Giannoni, Marc P., 2002. "Does Model Uncertainty Justify Caution? Robust Optimal Monetary Policy In A Forward-Looking Model," Macroeconomic Dynamics, Cambridge University Press, vol. 6(01), pages 111-144, February. [Downloadable!]
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  25. Carl Walsh, 2003. "Speed Limit Policies: The Output Gap and Optimal Monetary Policy," American Economic Review, American Economic Association, vol. 93(1), pages 265-278, March. [Downloadable!]
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Full references

Cited by:
(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. 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!]
    Other versions:
  2. Richhild Moessner, 2005. "Optimal discretionary policy and uncertainty about inflation persistence," Working Paper Series 540, European Central Bank. [Downloadable!]
  3. Carl E.Walsh, 2005. "Parameter misspecification and robust monetary policy rules," Working Paper Series 477, European Central Bank. [Downloadable!]
  4. Andrew T. Levin & Richhild Moessner, 2005. "Inflation persistence and monetary policy design - an overview," Working Paper Series 539, European Central Bank. [Downloadable!]
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