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Parameter Instability, Model Uncertainty and the Choice of Monetary Policy

  • Favero, Carlo A.
  • Milani, Fabio

This paper starts from the observation that parameter instability and model uncertainty are relevant problems for the analysis of monetary policy in small macroeconomic models. We propose to deal with these two problems by implementing a novel ‘thick recursive modelling’ approach. At each point in time we estimate all models generated by the combinations of a base-set of k observable regressors for aggregate demand and supply. We compute optimal monetary policies for all possible models and consider alternative ways of summarizing their distribution. Our main results show that thick recursive modelling delivers optimal policy rates that track the observed policy rates better than the optimal policy rates obtained under a constant parameter specification, with no role for model uncertainty.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4909.

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Date of creation: Feb 2005
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Handle: RePEc:cpr:ceprdp:4909
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  1. Rudebusch, G. & Svensson, L.E.O., 1999. "Eurosystem Monetary Targeting: Lessons from U.S. Data," Papers 672, Stockholm - International Economic Studies.
  2. Granger, Clive W. J. & Jeon, Yongil, 2004. "Thick modeling," Economic Modelling, Elsevier, vol. 21(2), pages 323-343, March.
  3. Pesaran, M Hashem & Timmermann, Allan, 2000. "A Recursive Modelling Approach to Predicting UK Stock Returns," Economic Journal, Royal Economic Society, vol. 110(460), pages 159-91, January.
  4. Lars Peter Hansen & Ellen R. McGrattan & Thomas J. Sargent, 1994. "Mechanics of forming and estimating dynamic linear economies," Staff Report 182, Federal Reserve Bank of Minneapolis.
  5. Richard Clarida & Jordi Gali & Mark Gertler, 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," NBER Working Papers 6442, National Bureau of Economic Research, Inc.
  6. 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.
  7. Glenn D. Rudebusch, 2001. "Term structure evidence on interest rate smoothing and monetary policy inertia," Working Paper Series 2001-02, Federal Reserve Bank of San Francisco.
  8. Sack, Brian, 2000. "Does the fed act gradually? A VAR analysis," Journal of Monetary Economics, Elsevier, vol. 46(1), pages 229-256, August.
  9. Robert J. Tetlow & Peter von zur Muehlen, 2000. "Robust monetary policy with misspecified models: does model uncertainty always call for attenuated policy?," Finance and Economics Discussion Series 2000-28, Board of Governors of the Federal Reserve System (U.S.).
  10. Gernot Doppelhofer & Ronald I. Miller & Xavier Sala-i-Martin, 2000. "Determinants of Long-Term Growth: A Bayesian Averaging of Classical Estimates (Bace) Approach," OECD Economics Department Working Papers 266, OECD Publishing.
  11. repec:cup:macdyn:v:6:y:2002:i:1:p:85-110 is not listed on IDEAS
  12. Pesaran, M Hashem & Timmermann, Allan, 1995. " Predictability of Stock Returns: Robustness and Economic Significance," Journal of Finance, American Finance Association, vol. 50(4), pages 1201-28, September.
  13. Hans M. Amman & David A. Kendrick, . "Computational Economics," Online economics textbooks, SUNY-Oswego, Department of Economics, number comp1, March.
  14. Brian Sack & Volker Wieland, 1999. "Interest-rate smoothing and optimal monetary policy: a review of recent empirical evidence," Finance and Economics Discussion Series 1999-39, Board of Governors of the Federal Reserve System (U.S.).
  15. repec:rus:hseeco:70719 is not listed on IDEAS
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