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Robust monetary policy with misspecified models: Does model uncertainty always call for attenuated policy?

  • J. Tetlow, Robert
  • von zur Muehlen, Peter

This paper explores Knightian model uncertainty as a possible explanation of the considerable difference between estimated interest rate rules and optimal feedback descriptions of monetary policy. We focus on two types of uncertainty: (i) unstructured model uncertainty reflected in additive shock error processes that result from omitted-variable misspecifications, and (ii) structured model uncertainty, where one or more parameters are identified as the source of misspecification. For an estimated forward-looking model of the U.S. economy, we find that rules that are robust against uncertainty, the nature of which is unspecifiable, or against one-time parametric shifts, are more aggressive than the optimal linear quadratic rule. However, policies designed to protect the economy against the worst-case consequences of misspecified dynamics are less aggressive and turn out to be good approximations of the estimated rule. A possible drawback of such policies is that the losses incurred from protecting against worst-case scenarios are concentrated among the same business cycle frequencies that normally occupy the attention of policymakers.

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Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 25 (2001)
Issue (Month): 6-7 (June)
Pages: 911-949

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Handle: RePEc:eee:dyncon:v:25:y:2001:i:6-7:p:911-949
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