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Welfare-maximizing monetary policy under parameter uncertainty

  • Rochelle M. Edge
  • Thomas Laubach
  • John C. Williams

This paper examines welfare-maximizing monetary policy in an estimated dynamic stochastic general equilibrium model of the U.S. economy where the policymaker faces uncertainty about the true values of model parameters. Uncertainty about parameters describing preferences and technology implies not only uncertainty about the dynamics of the economy. In addition, it implies uncertainty about the model's utility-based welfare criterion and model dynamics but also uncertainty about the "natural" rate of output that the central bank should aim to achieve absent nominal rigidities and the natural rate of interest that is consistent with this level of output equalling its natural rate absent nominal rigidities. We analyze the characteristics and performance of alternative monetary policy rules given the estimated uncertainty regarding parameter estimates. We find that the natural rates of interest and output are imprecisely estimated. We then show that optimal policies under parameter uncertainty respond primarily to indirect signals regarding natural rates extracted from observed prices and wages and the level of hours.

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Article provided by Federal Reserve Bank of San Francisco in its journal Proceedings.

Volume (Year): (2007)
Issue (Month): ()
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Handle: RePEc:fip:fedfpr:y:2007:x:2
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