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Monetary Policy and Uncertainty about the Natural Unemployment Rate

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Inflation-targeting central banks have only imperfect knowledge about the effect of policy decisions on inflation. An important source of uncertainty is the relationship between inflation and unemployment. This paper studies the optimal monetary policy in the presence of uncertainty about the natural unemployment rate, the short-run inflation-unemployment tradeoff and the degree of inflation persistence in a simple macroeconomic model, which incorporates rational learning by the central bank as well as private sector agents. Two conflicting motives drive the optimal policy. In the static version of the model, uncertainty provides a motive for the policymaker to move more cautiously than she would if she knew the true parameters. In the dynamic version, uncertainty also motivates an element of experimentation in policy. I find that the optimal policy that balances the cautionary and activist motives typically exhibits gradualism, that is, it still remains less aggressive than a policy that disregards parameter uncertainty. Exceptions occur when uncertainty is very high and in inflation close to target.

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  • Volker Wieland, 2003. "Monetary Policy and Uncertainty about the Natural Unemployment Rate," CFS Working Paper Series 2003/05, Center for Financial Studies.
  • Handle: RePEc:cfs:cfswop:wp200305
    Note: Helpful comments by John Leahy, Andrew Levin, Athanasios Orphanides, Richard Porter, Matthew Shapiro, Peter von zur Muehlen, Carl Walsh, David Wilcox and by seminar participants at the AEA Meetings 1997, the NBER Summer Institute 1997, the NBER URC Conference 1998, the Federal Reserve Board, Georgetown University, Goethe University Frankfurt, the University of Munich, the Institute of International Economic Studies of Stockholm University and Humboldt University Berlin as well as two anonymous referees are gratefully acknowledged. Also, I would like to thank Jeffrey Fuhrer for providing details on his estimation results. Any remaining errors are the sole responsibility of the author. This paper is a substantially revised and extended version of an earlier working paper that appeared in April 1998 in the Federal Reserve Board Discussion Paper Series, FEDS-98-22.
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    More about this item

    Keywords

    monetary policy; inflation targeting; parameter uncertainty; optimal learning; natural unemployment rate.;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E24 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity
    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis

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