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Imperfect Knowledge and the Pitfalls of Optimal Control Monetary Policy

  • Athanasios Orphanides

    ()

    (Central Bank of Cyprus)

  • John C. Williams

    ()

    (Federal Reserve Bank of San Francisco)

This paper examines the robustness characteristics of optimal control policies derived under the assumption of rational expectations to alternative models of expectations formation and uncertainty about the natural rates of interest and unemployment. We assume that agents have imperfect knowledge about the precise structure of the economy and form expectations using a forecasting model that they continuously update based on incoming data. We also allow for central bank uncertainty regarding the natural rates of interest and unemployment. We find that the optimal control policy derived under the assumption of perfect knowledge about the structure of the economy can perform poorly when knowledge is imperfect. These problems are exacerbated by natural rate uncertainty, even when the central bank's estimates of natural rates are efficient. We show that the optimal control approach can be made more robust to the presence of imperfect knowledge by deemphasizing the stabilization of real economic activity and interest rates relative to inflation in the central bank loss function. That is, robustness to the presence of imperfect knowledge about the economy provides an incentive to employ a "conservative" central banker. We then examine two types of simple monetary policy rules from the literature that have been found to be robust to model misspecification in other contexts. We find that these policies are robust to the alternative models of learning that we study and natural rate uncertainty and outperform the optimal control policy and generally perform as well as the robust optimal control policy that places less weight on stabilizing economic activity and interest rates.

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File URL: http://www.centralbank.gov.cy/media/pdf/NPWPE_No5_072008_.pdf
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Paper provided by Central Bank of Cyprus in its series Working Papers with number 2008-5.

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Length: 34 pages
Date of creation: Jul 2008
Date of revision:
Handle: RePEc:cyb:wpaper:2008-5
Contact details of provider: Web page: http://www.centralbank.gov.cy/nqcontent.cfm?a_id=1

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  1. Orphanides, Athanasios & Williams, John C., 2003. "Imperfect knowledge, inflation expectations, and monetary policy," CFS Working Paper Series 2003/40, Center for Financial Studies (CFS).
  2. Athanasios Orphanides & Richard D. Porter & David Reifschneider & Robert Tetlow & Frederico Finan, 1999. "Errors in the measurement of the output gap and the design of monetary policy," Finance and Economics Discussion Series 1999-45, Board of Governors of the Federal Reserve System (U.S.).
  3. Timothy Cogley & Thomas Sargent, . "Evolving Post-World War II U.S. Inflation Dynamics," Working Papers 2132872, Department of Economics, W. P. Carey School of Business, Arizona State University.
  4. Andrew T. Levin & John C. Williams, 2003. "Robust monetary policy with competing reference models," Working Paper Series 2003-10, Federal Reserve Bank of San Francisco.
  5. Taylor, John B., 1998. "The Robustness and Efficiency of Monetary Policy Rules as Guidelines for Interest Rate Setting by the European Central Bank," Seminar Papers 649, Stockholm University, Institute for International Economic Studies.
  6. Athanasios Orphanides & John C. Williams, 2007. "Inflation targeting under imperfect knowledge," Economic Review, Federal Reserve Bank of San Francisco, pages 1-23.
  7. Noah Williams & Lars E.O. Svensson, 2005. "Monetary Policy with Model Uncertainty: Distribution Forecast Targeting," Computing in Economics and Finance 2005 108, Society for Computational Economics.
  8. Ann-Charlotte Eliasson & Peter Isard & Douglas Laxton, 1999. "Simple Monetary Policy Rules Under Model Uncertainty," IMF Working Papers 99/75, International Monetary Fund.
  9. Alex Cukierman & Francesco Lippi, 2003. "Endogenous Monetary Policy with Unobserved Potential Output," CEIS Research Paper 26, Tor Vergata University, CEIS.
  10. Fabio Milani, 2005. "Expectations, Learning and Macroeconomic Persistence," Macroeconomics 0510022, EconWPA.
  11. Svensson, Lars E. O. & Woodford, Michael, 2000. "Indicator variables for optimal policy," Working Paper Series 0012, European Central Bank.
  12. Athanasios Orphanides & Simon Van_Norden, 2000. "The Reliability of Output Gap Estimates in Real Time," Econometric Society World Congress 2000 Contributed Papers 0768, Econometric Society.
  13. Svensson, Lars O & Tetlow, Robert J, 2005. "Optimal Policy Projections," MPRA Paper 839, University Library of Munich, Germany.
  14. Branch, William A. & Evans, George W., 2006. "A simple recursive forecasting model," Economics Letters, Elsevier, vol. 91(2), pages 158-166, May.
  15. Thomas Laubach, 1997. "Measuring the NAIRU : evidence from seven economies," Research Working Paper 97-13, Federal Reserve Bank of Kansas City.
  16. Levin, Andrew & Wieland, Volker & Williams, John C., 2003. "The performance of forecast-based monetary policy rules under model uncertainty," CFS Working Paper Series 2003/06, Center for Financial Studies (CFS).
  17. Todd E. Clark & Sharon Kozicki, 2004. "Estimating equilibrium real interest rates in real time," Research Working Paper RWP 04-08, Federal Reserve Bank of Kansas City.
  18. Marc Giannoni & Michael Woodford, 2004. "Optimal Inflation-Targeting Rules," NBER Chapters, in: The Inflation-Targeting Debate, pages 93-172 National Bureau of Economic Research, Inc.
  19. William A. Brock & Steven N. Durlauf & Kenneth D. West, 2004. "Model Uncertainty and Policy Evaluation: Some Theory and Empirics," NBER Working Papers 10916, National Bureau of Economic Research, Inc.
  20. Marcet, Albert & Sargent, Thomas J., 1989. "Convergence of least squares learning mechanisms in self-referential linear stochastic models," Journal of Economic Theory, Elsevier, vol. 48(2), pages 337-368, August.
  21. Robert J. Tetlow, 2010. "Real-time model uncertainty in the United States: 'Robust' policies put to the test," Finance and Economics Discussion Series 2010-15, Board of Governors of the Federal Reserve System (U.S.).
  22. Andrew Levin & Volker Wieland & John C. Williams, 1998. "Robustness of simple monetary policy rules under model uncertainty," Finance and Economics Discussion Series 1998-45, Board of Governors of the Federal Reserve System (U.S.).
  23. Thomas Laubach & John C. Williams, 2003. "Measuring the Natural Rate of Interest," The Review of Economics and Statistics, MIT Press, vol. 85(4), pages 1063-1070, November.
  24. Thomas J. Sargent, 2008. "Evolution and Intelligent Design," American Economic Review, American Economic Association, vol. 98(1), pages 5-37, March.
  25. Athanasios Orphanides & John C. Williams, 2002. "Robust monetary policy rules with unknown natural rates," Working Paper Series 2003-01, Federal Reserve Bank of San Francisco.
  26. John C. Williams, 1999. "Simple rules for monetary policy," Finance and Economics Discussion Series 1999-12, Board of Governors of the Federal Reserve System (U.S.).
  27. Mccallum, Bennet T., 1988. "Robustness properties of a rule for monetary policy," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 29(1), pages 173-203, January.
  28. Milton Friedman, 1947. "Lerner on the Economics of Control," Journal of Political Economy, University of Chicago Press, vol. 55, pages 405.
  29. Vitor Gaspar & Frank Smets & David Vestin, 2006. "Adaptive Learning, Persistence, and Optimal Monetary Policy," Journal of the European Economic Association, MIT Press, vol. 4(2-3), pages 376-385, 04-05.
  30. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  31. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, vol. 100(4), pages 1169-89, November.
  32. Schmidt-Hebbel, Klaus & Tapia, Matias, 2002. "Inflation targeting in Chile," The North American Journal of Economics and Finance, Elsevier, vol. 13(2), pages 125-146, August.
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