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Imperfect Knowledge and the Pitfalls of Optimal Control Monetary Policy

In: Monetary Policy under Uncertainty and Learning

  • Athanasios Orphanides

    (Central Bank of Cyprus)

  • John C. Williams

    (Federal Reserve Bank of San Francisco)

This paper examines the robustness characteristics of optimal control policies derived under the assumption of rational expectations to alternative models of expectations formation and uncertainty about the natural rates of interest and unemployment. We assume that agents have imperfect knowledge about the precise structure of the economy and form expectations using a forecasting model that they continuously update based on incoming data. We also allow for central bank uncertainty regarding the natural rates of interest and unemployment. We find that the optimal control policy derived under the assumption of perfect knowledge about the structure of the economy can perform poorly when knowledge is imperfect. These problems are exacerbated by natural rate uncertainty, even when the central bank's estimates of natural rates are efficient. We show that the optimal control approach can be made more robust to the presence of imperfect knowledge by deemphasizing the stabilization of real economic activity and interest rates relative to inflation in the central bank loss function. That is, robustness to the presence of imperfect knowledge about the economy provides an incentive to employ a "conservative" central banker. We then examine two types of simple monetary policy rules from the literature that have been found to be robust to model misspecification in other contexts. We find that these policies are robust to the alternative models of learning that we study and natural rate uncertainty and outperform the optimal control policy and generally perform as well as the robust optimal control policy that places less weight on stabilizing economic activity and interest rates.

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This chapter was published in: Klaus Schmidt-Hebbel & Carl E. Walsh & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series Editor) (ed.) Monetary Policy under Uncertainty and Learning, , chapter 4, pages 115-144, 2009.
This item is provided by Central Bank of Chile in its series Central Banking, Analysis, and Economic Policies Book Series with number v13c04pp115-144.
Handle: RePEc:chb:bcchsb:v13c04pp115-144
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  2. Svensson, Lars & Woodford, Michael, 2000. "Indicator Variables for Optimal Policy," Seminar Papers 688, Stockholm University, Institute for International Economic Studies.
  3. Timothy Cogley & Thomas J. Sargent, 2002. "Evolving Post-World War II U.S. Inflation Dynamics," NBER Chapters, in: NBER Macroeconomics Annual 2001, Volume 16, pages 331-388 National Bureau of Economic Research, Inc.
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  14. William A. Brock & Steven N. Durlauf & Kenneth D. West, 2004. "Model Uncertainty and Policy Evaluation: Some Theory and Empirics," NBER Working Papers 10916, National Bureau of Economic Research, Inc.
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  23. Athanasios Orphanides & Simon van Norden, 1999. "The reliability of output gap estimates in real time," Finance and Economics Discussion Series 1999-38, Board of Governors of the Federal Reserve System (U.S.).
  24. Thomas Laubach, 1997. "Measuring the NAIRU : evidence from seven economies," Research Working Paper 97-13, Federal Reserve Bank of Kansas City.
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  27. Marcet, Albert & Sargent, Thomas J., 1989. "Convergence of least squares learning mechanisms in self-referential linear stochastic models," Journal of Economic Theory, Elsevier, vol. 48(2), pages 337-368, August.
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  29. Vitor Gaspar & Frank Smets & David Vestin, 2006. "Adaptive Learning, Persistence, and Optimal Monetary Policy," Journal of the European Economic Association, MIT Press, vol. 4(2-3), pages 376-385, 04-05.
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  31. Athanasios Orphanides & Richard D. Porter & David Reifschneider & Robert Tetlow & Frederico Finan, 1999. "Errors in the measurement of the output gap and the design of monetary policy," Finance and Economics Discussion Series 1999-45, Board of Governors of the Federal Reserve System (U.S.).
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