Uncertainty and the open economy: a view through two different lenses

Under a Bayesian framework of model uncertainty, closed economy models of monetary policy typically suggest that policy responses should be attenuated. Conversely, under a Knightian view of uncertainty, where the policymaker cannot specify probabilities across alternative models, intensifying the policy response is recommended. In this paper, this dichotomy is found to extend to the case of a calibrated open economy new-Keynesian model. Two alternative model specifications are developed to examine the influence of the specification of the exchange rate on policy recommendations. One model specifies that the policymaker cares about the volatility of the exchange rate; a second model specifies a small exchange-rate channel relative to the standard channel of transmission. Although these alternative models produce quantitatively different results, qualitatively the models recommend standard results: policy attenuation if the policymaker maintains a Bayesian view of uncertainty and a more aggressive policy response, if the policymaker holds a Knightian view. Ultimately, resolving these policy proscriptions requires addressing the underlying beliefs about uncertainty of the policymaker, rather than the form of the underlying model.