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Parameters´ Instability, Model Uncertainty and Optimal Monetary Policy

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  • Carlo A. Favero

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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  2. Onatski, Alexei & Stock, James H., 2002. "Robust Monetary Policy Under Model Uncertainty In A Small Model Of The U.S. Economy," Macroeconomic Dynamics, Cambridge University Press, vol. 6(01), pages 85-110, February.
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  8. 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.
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Cited by:
  1. 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.
  2. Efrem Castelnuovo, 2003. "Squeezing the Interest Rate Smoothing Weight with a Hybrid Expectations Model," Working Papers 2003.6, Fondazione Eni Enrico Mattei.
  3. Efrem Castelnuovo, 2006. "Describing The Fed’S Conduct With Taylor Rules: Is Interest Rate Smoothing Important?," The IUP Journal of Monetary Economics, IUP Publications, vol. 0(3), pages 57-77, August.
  4. Efrem Castelnuovo, 2003. "Taylor Rules and Interest Rate Smoothing in the US and EMU," Macroeconomics 0303002, EconWPA.

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