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Caution and gradualism in monetary policy under uncertainty

  • Ben Martin
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    This paper explores the theoretical implication of parameter uncertainty for the optimal monetary policy reaction function. The policy-maker sets the nominal interest rate to meet an inflation target in a simple dynamic model of the economy. The paper looks at how parameter uncertainty in the transmission mechanism affects the optimal nominal and real interest rate relative to the case when the parameters are known. Its chief contribution is to show that three consequences are identified: conservatism (smaller deviations of real and nominal interest rates from some neutral level in response to inflationary shocks), gradualism (increased autocorrelation in real and nominal interest rates) and caution (a smaller cumulative policy response). The paper examines the sensitivity of these effects to different specifications of the transmission mechanism; in particular the introduction of an exchange rate channel. The paper also considers situations in which a more aggressive response may be called for.

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    File URL: http://www.bankofengland.co.uk/archive/Documents/historicpubs/workingpapers/1999/wp105.pdf
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    Paper provided by Bank of England in its series Bank of England working papers with number 105.

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    Date of creation: Dec 1999
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    Handle: RePEc:boe:boeewp:105
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    1. Michael Woodford, 1999. "Optimal Monetary Policy Inertia," NBER Working Papers 7261, National Bureau of Economic Research, Inc.
    2. Ben Martin & Chris Salmon, 1999. "Should uncertain monetary policy-makers do less?," Bank of England working papers 99, Bank of England.
    3. Svensson, Lars E O, 1996. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," CEPR Discussion Papers 1511, C.E.P.R. Discussion Papers.
    4. Geoffrey Shuetrim & Christopher Thompson, 2003. "The Implications of Uncertainty for Monetary Policy," The Economic Record, The Economic Society of Australia, vol. 79(246), pages 370-379, 09.
    5. Rudebusch, G.D. & Svensson, L.E.O., 1998. "Policy Rules for Inflation Targeting," Papers 637, Stockholm - International Economic Studies.
    6. Lars E. O. Svensson, 1997. "Inflation Targeting: Some Extensions," NBER Working Papers 5962, National Bureau of Economic Research, Inc.
    7. Lars E. O. Svensson, 2000. "Open-Economy Inflation Targeting," NBER Working Papers 6545, National Bureau of Economic Research, Inc.
    8. Alexei Onatski & James H. Stock, 1999. "Robust monetary policy under model uncertainty in a small model of the U.S. economy," Proceedings, Federal Reserve Bank of San Francisco.
    9. Marvin Goodfriend, 1990. "Interest rates and the conduct of monetary policy," Working Paper 90-06, Federal Reserve Bank of Richmond.
    10. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
    11. Brian Sack, 1998. "Does the Fed act gradually? a VAR analysis," Finance and Economics Discussion Series 1998-17, Board of Governors of the Federal Reserve System (U.S.).
    12. Turnovsky,Stephen J., 1977. "Macroeconomic Analysis and Stabilization Policy," Cambridge Books, Cambridge University Press, number 9780521291873.
    13. Stephen G. Cecchetti, 1998. "Policy rules and targets: framing the central banker's problem," Economic Policy Review, Federal Reserve Bank of New York, issue Jun, pages 1-14.
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