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Model Uncertainty And Monetary Policy

  • Richard Dennis

    ()

Model uncertainty has the potential to change importantly how monetary policy should be conducted, making it an issue that central banks cannot ignore. In this paper, I use a standard new Keynesian business cycle model to analyze the behavior of a central bank that conducts policy with discretion while fearing that its model is misspeci?fied. My main results are as follows. First, policy performance can be improved if the discretionary central bank implements a robust policy. This important result is obtained because the central bank's desire for robustness directs it to assertively stabilize inflation, thereby mit- igating the stabilization bias associated with discretionary policymaking. In effect, a fear of model uncertainty can act similarly to a commitment mechanism. Second, exploiting the connection between robust control and uncertainty aversion, I show that the central bank's fear of model misspeci?cation leads it to forecast future outcomes under the be- lief that inflation (in particular) will be persistent and have large unconditional variance, raising the probability of extreme outcomes. Private agents, however, anticipating the policy response, make decisions under the belief that in?ation will be more closely sta- bilized, that is, more tightly distributed, than under rational expectations. Third, as a technical contribution, I show how to solve an important class of linear-quadratic robust Markov-perfect Stackelberg problems.

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Paper provided by Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University in its series CAMA Working Papers with number 2009-04.

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Length: 30 pages
Date of creation: Aug 2008
Date of revision:
Handle: RePEc:een:camaaa:2009-04
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  13. Dennis, Richard & Leitemo, Kai & Söderström, Ulf, 2006. "Methods for Robust Control," CEPR Discussion Papers 5638, C.E.P.R. Discussion Papers.
  14. Ulf Soderstrom & Richard Dennis, 2003. "How Important is Precommitment for Monetary Policy?," Computing in Economics and Finance 2003 49, Society for Computational Economics.
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