Advanced Search
MyIDEAS: Login

Uncertainty about the Persistence of Periods with Large Price Shocks and the Optimal Reaction of the Monetary Authority

Contents:

Author Info

  • Gonzalez F.
  • Rodriguez A.

    ()
    (Economic Studies Division Bank of Mexico)

  • Gonzalez-Garcia J.R.
Registered author(s):

    Abstract

    Uncertainty about the persistence of periods characterized by large price shocks is an important aspect of monetary policy. This type of uncertainty posed some difficulties for central banks in 2004. This paper formalizes the treatment of this type of uncertainty by solving an optimal control problem in which the economy randomly alternates between two regimes characterized by different magnitudes of price shocks. By using an open economy model, we find that the optimal policy rule is both regime-contingent and robust. In particular, we find that: a) the optimal reaction of the interest rate is dependent on both the current regime and on the difference in the magnitude of the shocks between regimes; b) the alternation between regimes leads to more aggressive policy reactions with respect to inflation and the second lag of the real exchange rate; and c) after a robust selection of transition probabilities, the min-max probability of switching to the regime with large price shocks increases when such regime is more harmful. In general, cautious behavior renders smaller losses than recklessness for the central bank. This result argues in favor of caution over recklessness in the formulation of monetary policy when there is uncertainty about the persistence of periods with large price shocks

    Download Info

    If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
    File URL: http://repec.org/sce2005/up.2461.1107215202.pdf
    Download Restriction: no

    Bibliographic Info

    Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2005 with number 402.

    as in new window
    Length:
    Date of creation: 11 Nov 2005
    Date of revision:
    Handle: RePEc:sce:scecf5:402

    Contact details of provider:
    Email:
    Web page: http://comp-econ.org/
    More information through EDIRC

    Related research

    Keywords: monetary policy; Markov regime-switching; optimal control; robustness; model uncertainty; inflation targeting;

    Find related papers by JEL classification:

    This paper has been announced in the following NEP Reports:

    References

    References listed on IDEAS
    Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
    as in new window
    1. repec:cup:macdyn:v:6:y:2002:i:1:p:167-85 is not listed on IDEAS
    2. Michael Woodford, 2003. "Optimal Interest-Rate Smoothing," Review of Economic Studies, Wiley Blackwell, vol. 70(4), pages 861-886, October.
    3. Fabrizio Zampolli & Andrew Blake, 2005. "Time Consistent Policy in Markov Switching Models," Money Macro and Finance (MMF) Research Group Conference 2005 2, Money Macro and Finance Research Group.
    4. Onatski, Alexei & Stock, James H., 2002. "Robust Monetary Policy Under Model Uncertainty In A Small Model Of The U.S. Economy," Macroeconomic Dynamics, Cambridge University Press, vol. 6(01), pages 85-110, February.
    5. Ray C. Fair & John B. Taylor, 1980. "Solution and Maximum Likelihood Estimation of Dynamic Nonlinear Rational Expectations Models," Cowles Foundation Discussion Papers 564, Cowles Foundation for Research in Economics, Yale University.
    6. Becker, R. & Hall, S. & Rustem, B., 1994. "Robust optimal decisions with stochastic nonlinear economic systems," Journal of Economic Dynamics and Control, Elsevier, vol. 18(1), pages 125-147, January.
    7. Mark Salmon & Massimiliano Marcellino, 2001. "Robust Decision Theory and the Lucas Critique," Working Papers wp01-10, Warwick Business School, Finance Group.
    8. Laurence Ball, 1998. "Policy Rules for Open Economies," RBA Research Discussion Papers rdp9806, Reserve Bank of Australia.
    9. Schmitt-Grohe, Stephanie & Uribe, Martin, 2001. "Stabilization Policy and the Costs of Dollarization," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(2), pages 482-509, May.
    10. Fabio Milani, 2004. "Monetary Policy with a Wider Information Set: a Bayesian Model Averaging Approach," Macroeconomics 0401004, EconWPA.
    11. Giannoni, Marc P., 2002. "Does Model Uncertainty Justify Caution? Robust Optimal Monetary Policy In A Forward-Looking Model," Macroeconomic Dynamics, Cambridge University Press, vol. 6(01), pages 111-144, February.
    12. Carl E. Walsh, 2004. "Precautionary policies," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue feb.13.
    13. J. Tetlow, Robert & von zur Muehlen, Peter, 2001. "Robust monetary policy with misspecified models: Does model uncertainty always call for attenuated policy?," Journal of Economic Dynamics and Control, Elsevier, vol. 25(6-7), pages 911-949, June.
    14. Robert Tetlow & Peter von zur Muehlen, 2004. "Avoiding Nash Inflation: Bayesian and Robus Responses to Model Uncertainty," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 7(4), pages 869-899, October.
    15. Fabrizio Zampolli, 2004. "Optimal monetary policy in a regime-switching economy," Computing in Economics and Finance 2004 166, Society for Computational Economics.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as in new window

    Cited by:
    1. Andrew P Blake & Fabrizio Zampolli, 2006. "Optimal monetary policy in Markov-switching models with rational expectations agents," Bank of England working papers 298, Bank of England.

    Lists

    This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

    Statistics

    Access and download statistics

    Corrections

    When requesting a correction, please mention this item's handle: RePEc:sce:scecf5:402. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christopher F. Baum).

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If references are entirely missing, you can add them using this form.

    If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.