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Model Uncertainty and Monetary Policy

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  • Richard Dennis

    ()
    (Federal Reserve Bank of San Francisco)

Abstract

Model uncertainty has the potential to change importantly how monetary policy should be conducted, making it an issue that central banks cannot ignore. In this paper, I use a standard new Keynesian business cycle model to analyze the behavior of a central bank that conducts policy with discretion while fearing that its model is misspecified. My main results are as follows. First, policy performance can be improved if the discretionary central bank implements a robust policy. This important result is obtained because the central bank's desire for robustness directs it to assertively stabilize inflation, thereby mitigating the stabilization bias associated with discretionary policymaking. In effect, a fear of model uncertainty can act similarly to a commitment mechanism. Second, exploiting the connection between robust control and uncertainty aversion, I show that the central bank's fear of model misspecification leads it to forecast future outcomes under the belief that inflation (in particular) will be persistent and have large unconditional variance, raising the probability of extreme outcomes. Private agents, however, anticipating the policy response, make decisions under the belief that inflation will be more closely stabilized, that is, more tightly distributed, than under rational expectations. Third, as a technical contribution, I show how to solve an important class of linear-quadratic robust Markov-perfect Stackelberg problems.

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File URL: http://www.ncer.edu.au/papers/documents/NCER_WpNo30Aug08.pdf
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Bibliographic Info

Paper provided by National Centre for Econometric Research in its series NCER Working Paper Series with number 30.

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Length: 30 pages
Date of creation: 10 Aug 2008
Date of revision:
Handle: RePEc:qut:auncer:2008-19

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Keywords: Model uncertainty; robustness; uncertainty aversion; time-consistency.;

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References

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  1. A. Abel, 2010. "Asset prices under habit formation and catching up with the Jones," Levine's Working Paper Archive 1395, David K. Levine.
  2. Richard Dennis & Kai Leitemo & Ulf Söderström, 2007. "Monetary policy in a small open economy with a preference for robustness," Working Paper Series 2007-04, Federal Reserve Bank of San Francisco.
  3. Richard Dennis & Kai Leitemo & Ulf Soderstrom, 2006. "Methods for Robust Control," Working Papers 307, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  4. Lars Peter Hansen & Thomas J. Sargent & Thomas D. Tallarini Jr., 1997. "Robust Permanent Income and Pricing," Levine's Working Paper Archive 596, David K. Levine.
  5. Epstein, Larry G & Wang, Tan, 1994. "Intertemporal Asset Pricing Under Knightian Uncertainty," Econometrica, Econometric Society, vol. 62(2), pages 283-322, March.
  6. Hansen, Lars Peter & Sargent, Thomas J. & Turmuhambetova, Gauhar & Williams, Noah, 2006. "Robust control and model misspecification," Journal of Economic Theory, Elsevier, vol. 128(1), pages 45-90, May.
  7. Michael Woodford, 2005. "Robustly Optimal Monetary Policy with Near Rational Expectations," NBER Working Papers 11896, National Bureau of Economic Research, Inc.
  8. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
  9. Richard Dennis & Federico Ravenna, 2007. "Learning and optimal monetary policy," Working Paper Series 2007-19, Federal Reserve Bank of San Francisco.
  10. Giordani, Paolo & Söderlind, Paul, 2002. "Solution of Macromodels with Hansen-Sargent Robust Policies: Some Extensions," Working Paper Series in Economics and Finance 499, Stockholm School of Economics, revised 15 May 2003.
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  13. Richard Dennis, 2001. "Optimal policy in rational-expectations models: new solution algorithms," Working Paper Series 2001-09, Federal Reserve Bank of San Francisco.
  14. Richard Dennis & Ulf Soderstrom, 2002. "How important is precommitment for monetary policy?," Working Paper Series 2002-10, Federal Reserve Bank of San Francisco.
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Citations

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Cited by:
  1. Justin Svec, 2010. "Optimal Fiscal Policy with Robust Control," Working Papers 1004, College of the Holy Cross, Department of Economics.
  2. Giese, Guido & Wagner, Helmut, 2009. "A New Keynesian Model with Endogenous Frictions," Discussion Paper Series a520, Institute of Economic Research, Hitotsubashi University.
  3. Joshua Congdon-Hohman & Anil Nathan & Justin Svec, 2013. "Student Uncertainty and Major Choice," Working Papers 1301, College of the Holy Cross, Department of Economics.

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