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Parameters´ Instability, Model Uncertainty and Optimal Monetary Policy

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Carlo A. Favero

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Abstract

Observed policy rates are smooth. Why should central banks smooth interest rates? We investigate if model uncertainty and parameters instability are a valid reason. We do so by implementing a novel ´´thick recursive modelling´´ approach within the framework of small structural macroeconomic models. At each point in time we estimate all models generated by the combinations of a base-set of $k$ observable regressors. Our econometric procedure delivers 2$^{k}$ models for aggregate demand and supply at any point in time. We compute optimal monetary policies for each of these specifications and then take their average as our benchmark optimal monetary policy. We then compare observed policy rates with those generated by the traditional ´´thin modelling´´ approach to optimal monetary policy and to our proposed ´´thick modelling´´ approach. Our results confirm the difficulty of recovering the deep parameters describing the preferences of the monetary policy makers from their observed behaviour. However, they also show that thick recursive modelling can, at least partially, explain the observed interest rate smoothness.

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Paper provided by IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University in its series Working Papers with number 196.

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Handle: RePEc:igi:igierp:196

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  1. Glenn D. Rudebusch, 2001. "Term structure evidence on interest rate smoothing and monetary policy inertia," Working Papers in Applied Economic Theory 2001-02, Federal Reserve Bank of San Francisco. [Downloadable!]
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  2. Rudebusch, Glenn D. & Svensson, Lars E. O., 1999. "Eurosystem Monetary Targeting: Lessons from U.S. Data," Working Paper Series 92, Sveriges Riksbank (Central Bank of Sweden). [Downloadable!]
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  3. Gernot Doppelhofer & Ronald I. Miller & Xavier Sala-i-Martin, 2000. "Determinants of Long-Term Growth: A Bayesian Averaging of Classical Estimates (Bace) Approach," OECD Economics Department Working Papers 266, OECD, Economics Department. [Downloadable!]
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  4. Söderström, Ulf, 1999. "Monetary policy with uncertain parameters," Working Paper Series in Economics and Finance 308, Stockholm School of Economics. [Downloadable!]
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  5. Granger, Clive W. J. & Jeon, Yongil, 2004. "Thick modeling," Economic Modelling, Elsevier, vol. 21(2), pages 323-343, March. [Downloadable!] (restricted)
  6. Söderström, Ulf, 1999. "Should central banks be more aggressive?," Working Paper Series 84, Sveriges Riksbank (Central Bank of Sweden). [Downloadable!]
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  7. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules And Macroeconomic Stability: Evidence And Some Theory," The Quarterly Journal of Economics, MIT Press, vol. 115(1), pages 147-180, February. [Downloadable!] (restricted)
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  8. Hans M. Amman & David A. Kendrick, . "Computational Economics," Online economics textbooks, SUNY-Oswego, Department of Economics, number comp1, March. [Downloadable!]
  9. Lars Peter Hansen & Ellen R. McGrattan & Thomas J. Sargent, 1994. "Mechanics of forming and estimating dynamic linear economies," Staff Report 182, Federal Reserve Bank of Minneapolis. [Downloadable!]
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  10. Sack, Brian & Wieland, Volker, 2000. "Interest-rate smoothing and optimal monetary policy: a review of recent empirical evidence," Journal of Economics and Business, Elsevier, vol. 52(1-2), pages 205-228. [Downloadable!] (restricted)
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  11. Alexei Onatski & James H. Stock, 2000. "Robust Monetary Policy Under Model Uncertainty in a Small Model of the U.S. Economy," NBER Working Papers 7490, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  12. J. Tetlow, Robert & von zur Muehlen, Peter, 2001. "Robust monetary policy with misspecified models: Does model uncertainty always call for attenuated policy?," Journal of Economic Dynamics and Control, Elsevier, vol. 25(6-7), pages 911-949, June. [Downloadable!] (restricted)
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  13. Sack, Brian, 2000. "Does the fed act gradually? A VAR analysis," Journal of Monetary Economics, Elsevier, vol. 46(1), pages 229-256, August. [Downloadable!] (restricted)
  14. Pesaran, M Hashem & Timmermann, Allan, 2000. "A Recursive Modelling Approach to Predicting UK Stock Returns," Economic Journal, Royal Economic Society, vol. 110(460), pages 159-91, January. [Downloadable!] (restricted)
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  1. Efrem Castelnuovo, 2003. "Taylor Rules and Interest Rate Smoothing in the US and EMU," Macroeconomics 0303002, EconWPA. [Downloadable!]
  2. Efrem Castelnuovo, 2004. "Describing the Fed's conduct with simple Taylor rules: is interest rate smoothing important?," Money Macro and Finance (MMF) Research Group Conference 2003 12, Money Macro and Finance Research Group. [Downloadable!]
  3. Efrem Castelnuovo, 2002. "Squeezing the Interest Rate Smoothing Weight with a Hybrid Expectations Model," Macroeconomics 0211006, EconWPA. [Downloadable!]
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  4. Efrem Castelnuovo, 2003. "Describing the Fed's conduct with Taylor rules: is interest rate smoothing important?," Working Paper Series 232, European Central Bank. [Downloadable!]
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