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Robust monetary policy with imperfect knowledge

  • Orphanides, Athanasios
  • Williams, John C.

We examine the performance and robustness properties of monetary policy rules in an estimated macroeconomic model in which the economy undergoes structural change and where private agents and the central bank possess imperfect knowledge about the true structure of the economy. Private agents rely on an adaptive learning technology to form expectations and update their beliefs based on incoming data. Policymakers follow an interest rate rule aiming to maintain price stability and to minimize fluctuations of unemployment around its natural rate but are uncertain about the economy's natural rates of interest and unemployment. We show that in this environment the scope for economic stabilization is significantly reduced relative to an economy under rational expectations with perfect knowledge. Furthermore, policies that would be optimal under perfect knowledge can perform very poorly when knowledge is imperfect. Efficient policies that take account of private learning and misperceptions of natural rates call for more aggressive responses to inflation that would be optimal under perfect knowledge. We show that such policies not only improve performance in our baseline model, but are also quite robust to potential misspecification of private sector learning and the magnitude of variation in natural rates.

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Article provided by Elsevier in its journal Journal of Monetary Economics.

Volume (Year): 54 (2007)
Issue (Month): 5 (July)
Pages: 1406-1435

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Handle: RePEc:eee:moneco:v:54:y:2007:i:5:p:1406-1435
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505566

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