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Bayesian and adaptive optimal policy under model uncertainty

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  • Svensson, Lars E. O.
  • Williams, Noah

Abstract

We study the problem of a policymaker who seeks to set policy optimally in an economy where the true economic structure is unobserved, and policymakers optimally learn from their observations of the economy. This is a classic problem of learning and control, variants of which have been studied in the past, but little with forward-looking variables which are a key component of modern policy-relevant models. As in most Bayesian learning problems, the optimal policy typically includes an experimentation component reflecting the endogeneity of information. We develop algorithms to solve numerically for the Bayesian optimal policy (BOP). However the BOP is only feasible in relatively small models, and thus we also consider a simpler specification we term adaptive optimal policy (AOP) which allows policymakers to update their beliefs but shortcuts the experimentation motive. In our setting, the AOP is significantly easier to compute, and in many cases provides a good approximation to the BOP. We provide a simple example to illustrate the role of learning and experimentation in an MJLQ framework. --

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Bibliographic Info

Paper provided by Center for Financial Studies (CFS) in its series CFS Working Paper Series with number 2007/11.

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Date of creation: 2006
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Handle: RePEc:zbw:cfswop:200711

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Keywords: Optimal Monetary Policy; Learning; Recursive Saddlepoint Method;

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  1. Fabrizio Zampolli, 2006. "Optimal monetary policy in a regime-switching economy: the response to abrupt shifts in exchange rate dynamics," Bank of England working papers 297, Bank of England.
  2. Glenn D. Rudebusch & Lars E. O. Svensson, 1998. "Policy rules for inflation targeting," Working Papers in Applied Economic Theory 98-03, Federal Reserve Bank of San Francisco.
  3. Svensson, Lars E. O. & Williams, Noah, 2005. "Monetary policy with model uncertainty: distribution forecast targeting," Discussion Paper Series 1: Economic Studies 2005,35, Deutsche Bundesbank, Research Centre.
  4. Mewael F. Tesfaselassie & Eric Schaling & Sylvester Eijffinger, 2011. "Learning about the Term Structure and Optimal Rules for Inflation Targeting," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 43(8), pages 1685-1706, December.
  5. Timothy Cogley & Riccardo Colacito & Thomas J. Sargent, 2007. "Benefits from U.S. Monetary Policy Experimentation in the Days of Samuelson and Solow and Lucas," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 39(s1), pages 67-99, 02.
  6. Beck, Gunter W. & Wieland, Volker, 2002. "Learning and control in a changing economic environment," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 26(9-10), pages 1359-1377, August.
  7. do Val, Joao B. R. & Basar, Tamer, 1999. "Receding horizon control of jump linear systems and a macroeconomic policy problem," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 23(8), pages 1099-1131, August.
  8. Wieland, Volker, 2000. "Learning by doing and the value of optimal experimentation," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 24(4), pages 501-534, April.
  9. Albert Marcet & Ramon Marimon, 2011. "Recursive Contracts," Working Papers 552, Barcelona Graduate School of Economics.
  10. Kiefer, Nicholas M., 1989. "A value function arising in the economics of information," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 13(2), pages 201-223, April.
  11. Fabrizio Zampolli & Andrew P. Blake, 2005. "Time Consistent Policy in Markov Switching Models," Computing in Economics and Finance 2005, Society for Computational Economics 134, Society for Computational Economics.
  12. Lindé, Jesper, 2001. "Estimating New-Keynesian Phillips Curves: A Full Information Maximum Likelihood Approach," Working Paper Series 129, Sveriges Riksbank (Central Bank of Sweden), revised 30 Apr 2001.
  13. Ellison, Martin & Valla, Natacha, 2001. "Learning, uncertainty and central bank activism in an economy with strategic interactions," Journal of Monetary Economics, Elsevier, Elsevier, vol. 48(1), pages 153-171, August.
  14. Wieland Volker, 2006. "Monetary Policy and Uncertainty about the Natural Unemployment Rate: Brainard-Style Conservatism versus Experimental Activism," The B.E. Journal of Macroeconomics, De Gruyter, De Gruyter, vol. 6(1), pages 1-34, March.
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