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Monetary Policy With A Wider Information Set: A Bayesian Model Averaging Approach

  • Fabio Milani

Monetary policy has been usually analyzed in the context of small macroeconomic models where central banks are allowed to exploit a limited amount of information. Under these frameworks, researchers typically derive the optimality of aggressive monetary rules, contrasting with the observed policy conservatism and interest rate smoothing. This paper allows the central bank to exploit a wider information set, while taking into account the associated model uncertainty, by employing Bayesian Model Averaging with Markov Chain Model Composition (MC³). In this enriched environment, we derive the optimality of smoother and more cautious policy rates, together with clear gains in macroeconomic efficiency.

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File URL: http://www.blackwell-synergy.com/doi/abs/10.1111/j.1467-9485.2008.00446.x
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Article provided by Scottish Economic Society in its journal Scottish Journal of Political Economy.

Volume (Year): 55 (2008)
Issue (Month): 1 (02)
Pages: 1-30

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Handle: RePEc:bla:scotjp:v:55:y:2008:i:1:p:1-30
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  1. Christopher A. Sims, 2001. "Pitfalls of a Minimax Approach to Model Uncertainty," American Economic Review, American Economic Association, vol. 91(2), pages 51-54, May.
  2. Robert Tetlow, 2000. "The Fed Is Not As Ignorant As You Think," Computing in Economics and Finance 2000 202, Society for Computational Economics.
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  4. Michael Woodford, 2003. "Optimal Interest-Rate Smoothing," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 861-886.
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  9. Glenn D. Rudebusch & Lars E. O. Svensson, 1998. "Policy rules for inflation targeting," Proceedings, Federal Reserve Bank of San Francisco, issue Mar.
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  19. Sack, Brian & Wieland, Volker, 2000. "Interest-rate smoothing and optimal monetary policy: a review of recent empirical evidence," Journal of Economics and Business, Elsevier, vol. 52(1-2), pages 205-228.
  20. Favero, Carlo A. & Milani, Fabio, 2005. "Parameter Instability, Model Uncertainty and the Choice of Monetary Policy," CEPR Discussion Papers 4909, C.E.P.R. Discussion Papers.
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