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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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  1. Pesaran, M Hashem & Timmermann, Allan, 1995. " Predictability of Stock Returns: Robustness and Economic Significance," Journal of Finance, American Finance Association, vol. 50(4), pages 1201-28, September.
  2. Soderstrom, Ulf, 2002. " Monetary Policy with Uncertain Parameters," Scandinavian Journal of Economics, Wiley Blackwell, vol. 104(1), pages 125-45.
  3. Glenn D. Rudebusch, 2001. "Term structure evidence on interest rate smoothing and monetary policy inertia," Working Paper Series 2001-02, Federal Reserve Bank of San Francisco.
  4. Söderström, Ulf, 1999. "Should central banks be more aggressive?," Working Paper Series in Economics and Finance 309, Stockholm School of Economics.
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  7. Pesaran, M. H. & Timmermann, A., 1996. "A Recursive Modelling Approach to Predicting UK Stock Returns'," Cambridge Working Papers in Economics 9625, Faculty of Economics, University of Cambridge.
  8. 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.
  9. Alexei Onatski & James H. Stock, 1999. "Robust monetary policy under model uncertainty in a small model of the U.S. economy," Proceedings, Federal Reserve Bank of San Francisco.
  10. Sack, Brian, 2000. "Does the fed act gradually? A VAR analysis," Journal of Monetary Economics, Elsevier, vol. 46(1), pages 229-256, August.
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  14. Brian Sack & Volker Wieland, 1999. "Interest-rate smoothing and optimal monetary policy: a review of recent empirical evidence," Finance and Economics Discussion Series 1999-39, Board of Governors of the Federal Reserve System (U.S.).
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Cited by:
  1. Castelnuovo, Efrem, 2003. "Describing the Fed's conduct with Taylor rules: is interest rate smoothing important?," Working Paper Series 0232, European Central Bank.
  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, 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.
  4. Efrem Castelnuovo, 2003. "Taylor Rules and Interest Rate Smoothing in the US and EMU," Macroeconomics 0303002, EconWPA.

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