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How robustness can lower the cost of discretion

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  • Dennis, Richard

Abstract

Model uncertainty has the potential to change importantly how monetary policy is conducted, making it an issue that central banks cannot ignore. Using a standard new Keynesian business cycle model, this paper analyzes the behavior of a central bank that conducts policy under discretion while fearing that its model is misspecified. The main results are as follows. First, policy performance can be improved if the discretionary central bank implements a robust policy. This important result is obtained because the central bank's desire for robustness directs it to assertively stabilize inflation, thereby mitigating the stabilization bias associated with discretionary policymaking. Second, the central bank's fear of model misspecification leads it to forecast future outcomes under the belief that inflation (in particular) will be persistent and have large unconditional variance, raising the probability of extreme outcomes. Private agents, however, anticipating the policy response, make decisions under the belief that inflation will be more closely stabilized, that is, more tightly distributed, than under rational expectations. Finally, as a technical contribution, the paper shows how to solve with robustness an important class of linear-quadratic decision problems.

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  • Dennis, Richard, 2010. "How robustness can lower the cost of discretion," Journal of Monetary Economics, Elsevier, vol. 57(6), pages 653-667, September.
  • Handle: RePEc:eee:moneco:v:57:y:2010:i:6:p:653-667
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    Cited by:

    1. Young, Eric R., 2012. "Robust policymaking in the face of sudden stops," Journal of Monetary Economics, Elsevier, pages 512-527.
    2. Baumann Robert & Svec Justin, 2016. "The Impact of Political Uncertainty: A Robust Control Approach," The B.E. Journal of Economic Analysis & Policy, De Gruyter, pages 837-863.
    3. Dennis, Richard, 2014. "Imperfect credibility and robust monetary policy," Journal of Economic Dynamics and Control, Elsevier, pages 218-234.
    4. Tillmann, Peter, 2012. "Cross-checking optimal monetary policy with information from the Taylor rule," Economics Letters, Elsevier, vol. 117(1), pages 204-207.
    5. Luo, Yulei & Nie, Jun & Young, Eric R., 2014. "Model uncertainty and intertemporal tax smoothing," Journal of Economic Dynamics and Control, Elsevier, vol. 45(C), pages 289-314.
    6. Konstantinos Angelopoulos & George Economides & Apostolis Philippopoulos, 2012. "Public Good Provision with Robust Decision Making," CESifo Working Paper Series 3996, CESifo Group Munich.
    7. Konstantinos Angelopoulos & Jim Malley, 2010. "Fear of Model Misspecification and the Robustness Premium," CESifo Working Paper Series 3186, CESifo Group Munich.
    8. Chahrour, Ryan & Svec, Justin, 2014. "Optimal capital taxation and consumer uncertainty," Journal of Macroeconomics, Elsevier, pages 178-198.
    9. Sorge, Marco M., 2013. "Robust delegation with uncertain monetary policy preferences," Economic Modelling, Elsevier, pages 73-78.
    10. Svec, Justin, 2012. "Optimal fiscal policy with robust control," Journal of Economic Dynamics and Control, Elsevier, vol. 36(3), pages 349-368.
    11. Baumann Robert & Svec Justin, 2016. "The Impact of Political Uncertainty: A Robust Control Approach," The B.E. Journal of Economic Analysis & Policy, De Gruyter, pages 837-863.
    12. Chahrour, Ryan & Svec, Justin, 2014. "Optimal capital taxation and consumer uncertainty," Journal of Macroeconomics, Elsevier, pages 178-198.
    13. Olalla, Myriam García & Gómez, Alejandro Ruiz, 2011. "Robust control and central banking behaviour," Economic Modelling, Elsevier, vol. 28(3), pages 1265-1278, May.

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