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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. Ben Martin & Chris Salmon, 1999. "Should uncertain monetary policy-makers do less?," Bank of England working papers 99, Bank of England.
    2. Svensson, Lars E. O., 2000. "Open-economy inflation targeting," Journal of International Economics, Elsevier, vol. 50(1), pages 155-183, February.
    3. Lars E O Svensson, 1996. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," Bank of England working papers 56, Bank of England.
    4. Svensson, Lars E O, 1999. " Inflation Targeting: Some Extensions," Scandinavian Journal of Economics, Wiley Blackwell, vol. 101(3), pages 337-61, September.
    5. Woodford, Michael, 2000. "Optimal Monetary Policy Inertia," Seminar Papers 666, Stockholm University, Institute for International Economic Studies.
    6. Geoffrey Shuetrim & Christopher Thompson, 1999. "The Implications of Uncertainty for Monetary Policy," RBA Research Discussion Papers rdp1999-10, Reserve Bank of Australia.
    7. Glenn D. Rudebusch & Lars E. O. Svensson, 1998. "Policy rules for inflation targeting," Working Papers in Applied Economic Theory 98-03, Federal Reserve Bank of San Francisco.
    8. Marvin Goodfriend, 1990. "Interest rates and the conduct of monetary policy," Working Paper 90-06, Federal Reserve Bank of Richmond.
    9. Alexei Onatski & James H. Stock, 2000. "Robust Monetary Policy Under Model Uncertainty in a Small Model of the U.S. Economy," NBER Working Papers 7490, National Bureau of Economic Research, Inc.
    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. 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.
    12. Brian P. 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.).
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