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Bayesian versus robust control approach towards parameter uncertainty in monetary policymaking: how close are the outcomes? Some illustrating evidence from the EMU economies

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  • Juha Kilponen

    (Economics Department, Bank of Finland)

  • Marc-Alexandre Sénégas

    (GRAPE, University Montesquieu-Bordeaux IV)

  • Jouko Vilmunen

    (Research Department, Bank of Finland)

Abstract

This paper tries to assess the proximity of the macroeconomic outcomes which could arise from a monetary policymaking process based upon either a robust control or a Bayesian (à la Brainard) approach towards parameter uncertainty. We use a small, structural, backward-looking, aggregate model of the EMU economies as the basis for this empirical exercise. After deriving the optimal feedback rules which correspond to the two approaches that we consider in this study, we assess their relative performances with respect to the behavior of the output gap and the in.ation rate volatilities and compare with the no-uncertainty benchmark case. We are particularly interested in the output-in.ation variability trade-o¤ which is usually associated with the implementation of the optimal monetary policy rule in the literature and in the distortions that the presence of parameter uncertainty and its taking into account via the robust control approach or the Bayesian method may induce to this trade-o¤. The results show that the performances of the rules are not too divergent but they appear to be highly contingent upon the preference parameters in the model, ie the relative weight that the monetary authorities attach to output variability (w.r.t. in.ation variability) in the loss function and the robustness aversion of the policymaker which is associated to the robust control approach. In particular, non-standard shapes of the output-in.ation variability trade-o¤ obtain in the robust control case what may be due to the way the misspeci-.cations associated with the worst case scenario feedback into the structural equations of the model. When the rules are considered within the nominal model, the volatility outcomes appear to be closer to each other.

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Bibliographic Info

Paper provided by Money Macro and Finance Research Group in its series Money Macro and Finance (MMF) Research Group Conference 2006 with number 113.

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Date of creation: 02 Feb 2007
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Handle: RePEc:mmf:mmfc06:113

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Keywords: monetary policy; uncertainty; robust control; Brainard;

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  1. Andrew Levin & Volker Wieland & John C. Williams, 1998. "Robustness of simple monetary policy rules under model uncertainty," Finance and Economics Discussion Series 1998-45, Board of Governors of the Federal Reserve System (U.S.).
  2. Cecchetti, Stephen G & McConnell, Margaret M & Perez-Quiros, Gabriel, 2002. "Policymakers' Revealed Preferences and the Output-Inflation Variability Trade-Off: Implications for the European System of Central Banks," Manchester School, University of Manchester, vol. 70(4), pages 596-618, Special I.
  3. Rudebusch, G. & Svensson, L.E.O., 1999. "Eurosystem Monetary Targeting: Lessons from U.S. Data," Papers 672, Stockholm - International Economic Studies.
  4. Bean, Charles, 1998. "The New UK Monetary Arrangements: A View from the Literature," Economic Journal, Royal Economic Society, vol. 108(451), pages 1795-1809, November.
  5. Svensson, Lars E.O. & Rudebusch , Glenn, 1998. "Policy Rules for Inflation Targeting," Seminar Papers 637, Stockholm University, Institute for International Economic Studies.
  6. Stephen G. Cecchetti, 1996. "Practical issues in monetary policy targeting," Economic Review, Federal Reserve Bank of Cleveland, issue Q I, pages 2-15.
  7. Gerlach, Stefan & Smets, Frank, 1999. "Output gaps and monetary policy in the EMU area1," European Economic Review, Elsevier, vol. 43(4-6), pages 801-812, April.
  8. Taylor, John B, 1979. "Estimation and Control of a Macroeconomic Model with Rational Expectations," Econometrica, Econometric Society, vol. 47(5), pages 1267-86, September.
  9. Craine, Roger, 1979. "Optimal monetary policy with uncertainty," Journal of Economic Dynamics and Control, Elsevier, vol. 1(1), pages 59-83, February.
  10. Srour, Gabriel, 1999. "Inflation Targeting under Uncertainty," Technical Reports 85, Bank of Canada.
  11. Carlo Altavilla, 2003. "Assessing monetary rules performance across EMU countries," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 8(2), pages 131-151.
  12. Gerlach, Stefan & Schnabel, Gert, 1999. "The Taylor Rule and Interest Rates in the EMU Area," CEPR Discussion Papers 2271, C.E.P.R. Discussion Papers.
  13. Stephen G. Cecchetti, 1998. "Policy rules and targets: framing the central banker's problem," Economic Policy Review, Federal Reserve Bank of New York, issue Jun, pages 1-14.
  14. Fuhrer, Jeffrey C, 1997. "Inflation/Output Variance Trade-Offs and Optimal Monetary Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(2), pages 214-34, May.
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