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Monetary Policy with Model Uncertainty: Distribution Forecast Targeting

  • Svensson, Lars E O
  • Williams, Noah

We examine optimal and other monetary policies in a linear-quadratic setup with a relatively general form of model uncertainty, so-called Markov jump-linear-quadratic systems extended to include forward-looking variables and unobservable "modes." The form of model uncertainty our framework encompasses includes: simple i.i.d. model deviations; serially correlated model deviations; estimable regime-switching models; more complex structural uncertainty about very different models, for instance, backward- and forward-looking models; time-varying central-bank judgment about the state of model uncertainty; and so forth. We provide an algorithm for finding the optimal policy as well as solutions for arbitrary policy functions. This allows us to compute and plot consistent distribution forecasts - fan charts - of target variables and instruments. Our methods hence extend certainty equivalence and "mean forecast targeting" to more general certainty non-equivalence and "distribution forecast targeting."

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 6331.

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Date of creation: Jun 2007
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Handle: RePEc:cpr:ceprdp:6331
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  1. Svensson, Lars O & Tetlow, Robert J, 2005. "Optimal Policy Projections," MPRA Paper 839, University Library of Munich, Germany.
  2. Svensson, Lars, 1999. "Price Stability as a Target for Monetary Policy: Defining and Maintaining Price Stability," Seminar Papers 673, Stockholm University, Institute for International Economic Studies.
  3. Onatski, Alexei & Williams, Noah, 2002. "Modeling model uncertainty," Working Paper Series 0169, European Central Bank.
  4. Albert Marcet & Ramon Marimon, 2011. "Recursive Contracts," Working Papers 552, Barcelona Graduate School of Economics.
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  6. Fabrizio Zampolli & Andrew Blake, 2005. "Time Consistent Policy in Markov Switching Models," Money Macro and Finance (MMF) Research Group Conference 2005 2, Money Macro and Finance Research Group.
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  9. Troy Davig & Eric M. Leeper, 2005. "Generalizing the Taylor principle," Research Working Paper RWP 05-13, Federal Reserve Bank of Kansas City.
  10. Rudebusch, Glenn D & Svensson, Lars E O, 1998. "Policy Rules for Inflation Targeting," CEPR Discussion Papers 1999, C.E.P.R. Discussion Papers.
  11. Noah Williams & Lars E.O. Svensson, 2007. "Bayesian and Adaptive Optimal Policy under Model Uncertainty," 2007 Meeting Papers 446, Society for Economic Dynamics.
  12. Andrew T. Levin & Alexei Onatski & John C. Williams & Noah Williams, 2005. "Monetary policy under uncertainty in micro-founded macroeconometric models," Working Paper Series 2005-15, Federal Reserve Bank of San Francisco.
  13. Fabrizio Zampolli, 2006. "Optimal monetary policy in a regime-switching economy: the response to abrupt shifts in exchange rate dynamics," Bank of England working papers 297, Bank of England.
  14. Timothy Cogley & Thomas Sargent & Riccardo Colacito, 2005. "Benefits from U.S. Monetary Policy Experimentation in the Days of Samuelson," 2005 Meeting Papers 791, Society for Economic Dynamics.
  15. do Val, Joao B. R. & Basar, Tamer, 1999. "Receding horizon control of jump linear systems and a macroeconomic policy problem," Journal of Economic Dynamics and Control, Elsevier, vol. 23(8), pages 1099-1131, August.
  16. Svensson, Lars E O & Woodford, Michael, 2004. "Implementing Optimal Policy Through Inflation-Forecast Targeting," CEPR Discussion Papers 4229, C.E.P.R. Discussion Papers.
  17. James A. Kahn & Robert Rich, 2003. "Tracking the new economy: using growth theory to detect changes in trend productivity," Staff Reports 159, Federal Reserve Bank of New York.
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  19. Professor Lars E O Svensson, 2001. "Independent review of the operation of monetary policy in New Zealand," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, vol. 64, March.
  20. Linde, Jesper, 2005. "Estimating New-Keynesian Phillips curves: A full information maximum likelihood approach," Journal of Monetary Economics, Elsevier, vol. 52(6), pages 1135-1149, September.
  21. Backus, David & Driffill, John, 1986. "The Consistency of Optimal Policy in Stochastic Rational Expectations Models," CEPR Discussion Papers 124, C.E.P.R. Discussion Papers.
  22. Lars E O Svensson, 2005. "Monetary Policy with Judgment: Forecast Targeting," International Journal of Central Banking, International Journal of Central Banking, vol. 1(1), May.
  23. Roger E.A. Farmer & Daniel F. Waggoner & Tao Zha, 2007. "Understanding the New-Keynesian Model when Monetary Policy Switches Regimes," NBER Working Papers 12965, National Bureau of Economic Research, Inc.
  24. Alan Greenspan, 2004. "Risk and Uncertainty in Monetary Policy," American Economic Review, American Economic Association, vol. 94(2), pages 33-40, May.
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  26. Timothy Cogley & Riccardo Colacito & Thomas J. Sargent, 2007. "Benefits from U.S. Monetary Policy Experimentation in the Days of Samuelson and Solow and Lucas," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 39(s1), pages 67-99, 02.
  27. Alan S. Blinder & Ricardo Reis, 2005. "Understanding the Greenspan Standard," Working Papers 88, Princeton University, Department of Economics, Center for Economic Policy Studies..
  28. Chow, Gregory C, 1973. "Effect of Uncertainty on Optimal Control Policies," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 14(3), pages 632-45, October.
  29. Chang-Jin Kim & Charles R. Nelson, 1999. "State-Space Models with Regime Switching: Classical and Gibbs-Sampling Approaches with Applications," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262112388, June.
  30. Christopher A. Sims, 2002. "The Role of Models and Probabilities in the Monetary Policy Process," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 33(2), pages 1-62.
  31. Hamilton, James D, 1989. "A New Approach to the Economic Analysis of Nonstationary Time Series and the Business Cycle," Econometrica, Econometric Society, vol. 57(2), pages 357-84, March.
  32. Alan Greenspan, 2005. "Reflections on central banking," Speech 126, Board of Governors of the Federal Reserve System (U.S.).
  33. Soderlind, Paul, 1999. "Solution and estimation of RE macromodels with optimal policy," European Economic Review, Elsevier, vol. 43(4-6), pages 813-823, April.
  34. Gilles Oudiz & Jeffrey Sachs, 1985. "International Policy Coordination in Dynamic Macroeconomic Models," NBER Chapters, in: International Economic Policy Coordination, pages 274-330 National Bureau of Economic Research, Inc.
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