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Robust monetary policy in a model with financial distress

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  • Gerke, Rafael
  • Hammermann, Felix
  • Lewis, Vivien

Abstract

We characterise optimal discretionary monetary policy responses to cost-push shocks and to financial distress in the presence of model uncertainty. Under robust control, the central bank reacts more aggressively to both types of shocks, and less to the lagged policy rate, than if the true model is known. We document how the objective to stabilise the policy instrument conflicts with the concern for robustness to model misspecification: the higher the weight on interest rate stabilisation in the loss function, the more the robust policy deviates from the optimal policy under rational expectations. Financial distress is akin to a contractionary demand shock and does not induce a policy trade-off; thus model uncertainty does not constrain monetary policy in the face of financial shocks.

Suggested Citation

  • Gerke, Rafael & Hammermann, Felix & Lewis, Vivien, 2012. "Robust monetary policy in a model with financial distress," Journal of Macroeconomics, Elsevier, vol. 34(2), pages 318-325.
  • Handle: RePEc:eee:jmacro:v:34:y:2012:i:2:p:318-325
    DOI: 10.1016/j.jmacro.2012.01.006
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    More about this item

    Keywords

    Optimal monetary policy; Discretion; Model uncertainty; Interest rate stabilisation; Robust control;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles

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