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Welfare-Maximizing Monetary Policy under Parameter Uncertainty

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  • Thomas Laubach

    (Federal Reserve Board)

  • John C. Williams

    (Federal Reserve Bank of San Francisco)

  • Rochelle M. Edge

    (Federal Reserve Board))

Abstract

This paper examines welfare-maximizing monetary policy in an estimated dynamic stochastic general equilibrium model of the U.S. economy where the policymaker faces uncertainty about the true values of model parameters. Uncertainty about parameters describing preferences and technology implies not only uncertainty about model dynamics but also uncertainty about the “natural” level of output that the central bank should aim to achieve. We analyze the characteristics and performance of alternative monetary policy rules given the estimated covariance of parameter estimates. We find that the natural rates of output is very imprecisely estimated. We then show that policy rules that rely on the output gap and therefore estimates estimates of the natural rate of output perform poorly under parameter uncertainty. Instead, optimal policies respond primarily to indirect signals regarding natural rates extracted from observed prices and wages.

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2007 Meeting Papers with number 311.

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Date of creation: 2007
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Handle: RePEc:red:sed007:311

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Cited by:
  1. André P. Calmon & Thomas Vallée & João B. R. Do Val, 2009. "Monetary policy as a source of uncertainty," Working Papers hal-00422454, HAL.
  2. Avouyi-Dovi, Sanvi & Sahuc, Jean-Guillaume, 2011. "On the welfare costs of misspecified monetary policy objectives," Journal of Macroeconomics, Elsevier, vol. 33(2), pages 151-161, June.
  3. John C. Williams, 2013. "A defense of moderation in monetary policy," Working Paper Series 2013-15, Federal Reserve Bank of San Francisco.
  4. Rochelle M. Edge & Thomas Laubach & John C. Williams, 2008. "Welfare-Maximizing Monetary Policy Under Parameter Uncertainty," CAMA Working Papers 2008-16, Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University.
  5. Paez-Farrell, Juan, 2014. "Resuscitating the ad hoc loss function for monetary policy analysis," Economics Letters, Elsevier, vol. 123(3), pages 313-317.
  6. Sala, Luca & Söderström, Ulf & Trigari, Antonella, 2008. "Monetary policy under uncertainty in an estimated model with labor market frictions," Journal of Monetary Economics, Elsevier, vol. 55(5), pages 983-1006, July.
  7. Carl Walsh, 2007. "Inflation Targeting and the Role of Real Objectives," Research and Policy Notes 2007/02, Czech National Bank, Research Department.
  8. Pei-Tha Gan, 2014. "The Optimal Economic Uncertainty Index: A Grid Search Application," Computational Economics, Society for Computational Economics, vol. 43(2), pages 159-182, February.

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