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Parameter Instability, Model Uncertainty and the Choice of Monetary Policy

  • Favero Carlo A.

    ()

    (IGIER, Bocconi University and CEPR)

  • Milani Fabio

    ()

    (Princeton University)

This paper starts from the observation that parameter instability and model uncertainty are relevant problems for the analysis of monetary policy in small macroeconomic models. We propose to deal with these two problems by implementing a novel "thick recursive modelling" approach. At each point in time we estimate all models generated by the combinations of a base-set of k observable regressors for aggregate demand and supply. We compute optimal monetary policies for all possible models and then consider alternative ways of summarizing their distribution. Our main results show that thick recursive modelling delivers optimal policy rates that track the observed policy rates better than the optimal policy rates obtained under a constant parameter specification with no role for model uncertainty.

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Article provided by De Gruyter in its journal The B.E. Journal of Macroeconomics.

Volume (Year): 5 (2005)
Issue (Month): 1 (February)
Pages: 1-33

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Handle: RePEc:bpj:bejmac:v:topics.5:y:2005:i:1:n:4
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  1. Rudebusch, Glenn & Svensson, Lars, 1999. "Eurosystem Monetary Targeting: Lessons from U.S. Data," Seminar Papers 672, Stockholm University, Institute for International Economic Studies.
  2. Rudebusch, Glenn D., 2002. "Term structure evidence on interest rate smoothing and monetary policy inertia," Journal of Monetary Economics, Elsevier, vol. 49(6), pages 1161-1187, September.
  3. Allan Timmermann & M. Hashem Pesaran, 1999. "A Recursive Modelling Approach to Predicting UK Stock Returns," FMG Discussion Papers dp322, Financial Markets Group.
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  6. repec:cup:macdyn:v:6:y:2002:i:1:p:85-110 is not listed on IDEAS
  7. 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.).
  8. Granger, Clive W. J. & Jeon, Yongil, 2004. "Thick modeling," Economic Modelling, Elsevier, vol. 21(2), pages 323-343, March.
  9. Xavier Sala-I-Martin & Gernot Doppelhofer & Ronald I. Miller, 2004. "Determinants of Long-Term Growth: A Bayesian Averaging of Classical Estimates (BACE) Approach," American Economic Review, American Economic Association, vol. 94(4), pages 813-835, September.
  10. Sack, Brian, 2000. "Does the fed act gradually? A VAR analysis," Journal of Monetary Economics, Elsevier, vol. 46(1), pages 229-256, August.
  11. Brian Sack & Volker Wieland, 1999. "Interest-rate smoothing and optimal monetary policy: a review of recent empirical evidence," Finance and Economics Discussion Series 1999-39, Board of Governors of the Federal Reserve System (U.S.).
  12. 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.
  13. repec:rus:hseeco:70719 is not listed on IDEAS
  14. Lars Peter Hansen & Ellen R. McGrattan & Thomas J. Sargent, 1994. "Mechanics of forming and estimating dynamic linear economies," Staff Report 182, Federal Reserve Bank of Minneapolis.
  15. Pesaran, M Hashem & Timmermann, Allan, 1995. " Predictability of Stock Returns: Robustness and Economic Significance," Journal of Finance, American Finance Association, vol. 50(4), pages 1201-28, September.
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