Optimal monetary policy in a regime-switching economy
AbstractThis paper is of interest for two reasons. First, it provides a simple algorithm for solving an optimal control problem in which the law of motion of the economy is a Markov regime-switching vector autoregression. Second, it applies this algorithm to study optimal monetary policy in a stylised small open economy model, which alternates randomly between two states: a `no-bubble' regime, in which the exchange rate fluctuates, in a stationary way, around its long-run equilibrium; and a `bubble' regime, in which the exchange rate (absent any offsetting impact of policy or exogenous shocks) increasingly deviates from it. We compute the optimal policy rule for this economy, as opposed to an optimised reaction function. This rule is regime-contingent in that policy response varies according to whether the economy is experiencing a bubble or not. The main results are as follows. First, while the optimal weights on output and inflation do not vary much between regimes, the optimal reaction to the asset price is highly dependent on the regime as well as the stochastic properties of the bubble. Second, uncertainty about the regime makes policy more cautious. Third, a policymaker uncertain about the true stochastic properties of the asset price tends to obtain a `robust' performance (i.e. minmax outcome) by responding little to the asset price. Finally, over-estimating the probability of an incipient bubble is generally more costly than under-estimating it
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Bibliographic InfoPaper provided by Society for Computational Economics in its series Computing in Economics and Finance 2004 with number 166.
Date of creation: 11 Aug 2004
Date of revision:
asset prices; policy rules; asymmetric risk;
Find related papers by JEL classification:
- C6 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling
- E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
This paper has been announced in the following NEP Reports:
- NEP-ALL-2004-08-16 (All new papers)
- NEP-CBA-2004-08-16 (Central Banking)
- NEP-IFN-2004-08-16 (International Finance)
- NEP-MON-2004-08-16 (Monetary Economics)
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