Uncertainty about the Persistence of Periods with Large Price Shocks and the Optimal Reaction of the Monetary Authority
AbstractUncertainty 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 InfoIf 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.
Bibliographic InfoPaper provided by Society for Computational Economics in its series Computing in Economics and Finance 2005 with number 402.
Date of creation: 11 Nov 2005
Date of revision:
monetary policy; Markov regime-switching; optimal control; robustness; model uncertainty; inflation targeting;
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-2005-11-19 (All new papers)
- NEP-CBA-2005-11-19 (Central Banking)
- NEP-MAC-2005-11-19 (Macroeconomics)
- NEP-MON-2005-11-19 (Monetary Economics)
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.:
- repec:cup:macdyn:v:6:y:2002:i:1:p:167-85 is not listed on IDEAS
- Michael Woodford, 2003.
"Optimal Interest-Rate Smoothing,"
Review of Economic Studies,
Wiley Blackwell, vol. 70(4), pages 861-886, October.
- 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.
- Onatski, Alexei & Stock, James H., 2002.
"Robust Monetary Policy Under Model Uncertainty In A Small Model Of The U.S. Economy,"
Cambridge University Press, vol. 6(01), pages 85-110, February.
- Alexei Onatski & James H. Stock, 1999. "Robust monetary policy under model uncertainty in a small model of the U.S. economy," Proceedings, Federal Reserve Bank of San Francisco.
- Alexei Onatski & James H. Stock, 2000. "Robust Monetary Policy Under Model Uncertainty in a Small Model of the U.S. Economy," NBER Working Papers 7490, National Bureau of Economic Research, Inc.
- 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.
- Fair, Ray C & Taylor, John B, 1983. "Solution and Maximum Likelihood Estimation of Dynamic Nonlinear Rational Expectations Models," Econometrica, Econometric Society, vol. 51(4), pages 1169-85, July.
- Ray C. Fair & John B. Taylor, 1980. "Solution and Maximum Likelihood Estimation of Dynamic Nonlinear RationalExpectations Models," NBER Technical Working Papers 0005, National Bureau of Economic Research, Inc.
- 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.
- Mark Salmon & Massimiliano Marcellino, 2001.
"Robust Decision Theory and the Lucas Critique,"
wp01-10, Warwick Business School, Finance Group.
- Laurence Ball, 1998.
"Policy Rules for Open Economies,"
RBA Research Discussion Papers
rdp9806, Reserve Bank of Australia.
- 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.
- Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Stabilization policy and the costs of dollarization," Proceedings, Federal Reserve Bank of Cleveland, pages 482-517.
- Stephanie Schmitt-Grohe & Martin Uribe, 2000. "Stabilization Policy and the Costs of Dollarization," Departmental Working Papers 200006, Rutgers University, Department of Economics.
- Fabio Milani, 2004.
"Monetary Policy with a Wider Information Set: a Bayesian Model Averaging Approach,"
- Fabio Milani, 2008. "Monetary Policy With A Wider Information Set: A Bayesian Model Averaging Approach," Scottish Journal of Political Economy, Scottish Economic Society, vol. 55(1), pages 1-30, 02.
- 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.
- Carl E. Walsh, 2004. "Precautionary policies," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue feb.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.
- Robert J. Tetlow & Peter von zur Muehlen, 2000. "Robust monetary policy with misspecified models: does model uncertainty always call for attenuated policy?," Finance and Economics Discussion Series 2000-28, Board of Governors of the Federal Reserve System (U.S.).
- 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.
- Robert J. Tetlow & Peter von zur Muehlen, 2002. "Avoiding Nash inflation: Bayesian and robust responses to model uncertainty," Finance and Economics Discussion Series 2002-9, Board of Governors of the Federal Reserve System (U.S.).
- Fabrizio Zampolli, 2004. "Optimal monetary policy in a regime-switching economy," Computing in Economics and Finance 2004 166, Society for Computational Economics.
- 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.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christopher F. Baum).
If references are entirely missing, you can add them using this form.