One Who Hesitates Is Lost: Monetary Policy Under Model Uncertainty and Model Misspecification

This paper investigates how different parametrisations of the monetary policy reaction function and different mechanisms of expectation formation shape the macroeconomic outcomes in the estimated Smets–Wouters type of DSGE model. The initial macroeconomic conditions of the simulations correspond to the high inflation environment of early 2022. The simulation results show that, under the hybrid expectations, the terminal monetary policy rate is significantly higher than under the rational expectations for all Taylor rule parametrisations. Under hybrid expectations, the inflation rate is much more persistent than under the rational expectations; three years is not enough to reach the inflation target of two percent, even for the quite hawkish calibration of the Taylor rule. In the modelled economy, relatively fast inflation stabilisation for the hawkish Taylor rule has its own price in form of the cumulative output loss when compared with the dovish Taylor rule. Simulations are also performed for the case where the central bank misspecifies the expectation formation mechanism in the DSGE model and follows an interest rate path implied by a false model. The results show that the hawkish reaction is preferable for both correctly and incorrectly specified models.