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Optimal Monetary Policy under Risk and Uncertainty

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  • D Nocetti

Abstract

This paper seeks to characterise optimal monetary policy rules in the presence of risk and uncertainty. I explore a situation in which the true parameters and the true structure of the economy are unknown to the policymaker, and he is reluctant to make a decision based on a single distribution estimate (i.e. he faces Knightian uncertainty). I show analytically that if the policymaker does not know the true structure of the economy he will be more cautious than in the case of only parameter risk. Further, I show that Knightian uncertainty can also lead to an extra precautionary motive when one considers its interaction with parameter risk. In a simple exercise, I provide empirical estimates that demonstrate that adjustments due to parameter and structural risk and Knightian uncertainty can potentially be quite large.

Suggested Citation

  • D Nocetti, 2007. "Optimal Monetary Policy under Risk and Uncertainty," Economic Issues Journal Articles, Economic Issues, vol. 12(1), pages 93-108, March.
  • Handle: RePEc:eis:articl:107nocetti
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    References listed on IDEAS

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    1. Foster, James E & Frierman, Michael, 1990. "Learning Rational Expectations: Classical Conditions Ensure Uniqueness and Global Stability," Economica, London School of Economics and Political Science, pages 439-453.
    2. Bond, Eric W. & Crocker, Keith J., 1997. "Hardball and the soft touch: The economics of optimal insurance contracts with costly state verification and endogenous monitoring costs," Journal of Public Economics, Elsevier, pages 239-264.
    3. Hardle, Wolfgang & Linton, Oliver, 1986. "Applied nonparametric methods," Handbook of Econometrics,in: R. F. Engle & D. McFadden (ed.), Handbook of Econometrics, edition 1, volume 4, chapter 38, pages 2295-2339 Elsevier.
    4. Keith J. Crocker & John Morgan, 1998. "Is Honesty the Best Policy? Curtailing Insurance Fraud through Optimal Incentive Contracts," Journal of Political Economy, University of Chicago Press, vol. 106(2), pages 355-375, April.
    5. Bond, Eric W. & Crocker, Keith J., 1997. "Hardball and the soft touch: The economics of optimal insurance contracts with costly state verification and endogenous monitoring costs," Journal of Public Economics, Elsevier, pages 239-264.
    6. Hardle, Wolfgang & Linton, Oliver, 1986. "Applied nonparametric methods," Handbook of Econometrics,in: R. F. Engle & D. McFadden (ed.), Handbook of Econometrics, edition 1, volume 4, chapter 38, pages 2295-2339 Elsevier.
    7. Charles E. Hyde & James A. Vercammen, 1997. "Costly Yield Verification, Moral Hazard, And Crop Insurance Contract Form," Journal of Agricultural Economics, Wiley Blackwell, vol. 48(1-3), pages 393-407.
    8. Gravel, N. & Boismenu, G. & Loranger, J.G., 1992. "Regime d'accumulation et approche de la regulation : un modele a equations simultanees," Cahiers de recherche 9218, Universite de Montreal, Departement de sciences economiques.
    9. Myerson, Roger B, 1979. "Incentive Compatibility and the Bargaining Problem," Econometrica, Econometric Society, vol. 47(1), pages 61-73, January.
    10. Lacker, Jeffrey M & Weinberg, John A, 1989. "Optimal Contracts under Costly State Falsification," Journal of Political Economy, University of Chicago Press, vol. 97(6), pages 1345-1363, December.
    11. Hardle, Wolfgang & Linton, Oliver, 1986. "Applied nonparametric methods," Handbook of Econometrics,in: R. F. Engle & D. McFadden (ed.), Handbook of Econometrics, edition 1, volume 4, chapter 38, pages 2295-2339 Elsevier.
    12. Louis Kaplow, 1994. "Optimal Insurance Contracts When Establishing the Amount of Losses Is Costly," The Geneva Risk and Insurance Review, Palgrave Macmillan;International Association for the Study of Insurance Economics (The Geneva Association), vol. 19(2), pages 139-152, December.
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    Cited by:

    1. P Arestis & A Mihailov, 2009. "Flexible Rules cum Constrained Discretion: A New Consensus in Monetary Policy," Economic Issues Journal Articles, Economic Issues, vol. 14(2), pages 27-54, September.

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