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Parameter Instability, Model Uncertainty and the Choice of Monetary Policy

Author

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  • Favero, Carlo A.
  • Milani, Fabio

Abstract

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.

Suggested Citation

  • Favero, Carlo A. & Milani, Fabio, 2005. "Parameter Instability, Model Uncertainty and the Choice of Monetary Policy," CEPR Discussion Papers 4909, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:4909
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    References listed on IDEAS

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    1. Richard Clarida & Jordi Galí & Mark Gertler, 2000. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," The Quarterly Journal of Economics, Oxford University Press, vol. 115(1), pages 147-180.
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    8. J. Tetlow, Robert & von zur Muehlen, Peter, 2001. "Robust monetary policy with misspecified models: Does model uncertainty always call for attenuated policy?," Journal of Economic Dynamics and Control, Elsevier, vol. 25(6-7), pages 911-949, June.
    9. Sack, Brian, 2000. "Does the fed act gradually? A VAR analysis," Journal of Monetary Economics, Elsevier, vol. 46(1), pages 229-256, August.
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    Citations

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    Cited by:

    1. Malley, Jim & Moutos, Thomas, 2006. "Do excessive wage increases raise imports?: Theory and evidence," Japan and the World Economy, Elsevier, pages 194-220.
    2. Oreste Napolitano & Alberto Montagnoli, 2010. "The European Unemployment Gap and the Role of Monetary Policy," Economics Bulletin, AccessEcon, vol. 30(2), pages 1346-1358.
    3. Arnulfo Rodríguez & Pedro N. Rodríguez, 2007. "Recursive Thick Modeling and the Choice of Monetary Policy in Mexico," Working Papers 2007-04, Banco de México.
    4. Arnulfo Rodriguez & Pedro N. Rodriguez, 2006. "Recursive Thick Modeling and the Choice of Monetary Policy in Mexico," Computing in Economics and Finance 2006 30, Society for Computational Economics.
    5. Jean-Paul Lam & William Scarth, 2002. "Alternative Public Spending Rules and Output Volatility," Staff Working Papers 02-37, Bank of Canada.
    6. Fabio Milani, 2008. "Monetary Policy With A Wider Information Set: A Bayesian Model Averaging Approach," Scottish Journal of Political Economy, Scottish Economic Society, vol. 55(1), pages 1-30, February.
    7. Efrem Castelnuovo, 2003. "Taylor Rules and Interest Rate Smoothing in the US and EMU," Macroeconomics 0303002, EconWPA.
    8. Efrem Castelnuovo, 2002. "Squeezing the Interest Rate Smoothing Weight with a Hybrid Expectations Model," Macroeconomics 0211006, EconWPA.

    More about this item

    Keywords

    model uncertainty; optimal monetary policy; parameter instability;

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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