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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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File URL: http://cbe.anu.edu.au/research/papers/camawpapers/Papers/2009/Dennis_42009.pdf
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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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  1. Richard Dennis & Kai Leitemo & Ulf Söderström, 2006. "Methods for robust control," Working Paper Series 2006-10, Federal Reserve Bank of San Francisco.
  2. Clarida, R. & Gali, J. & Gertler, M., 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Working Papers 99-13, C.V. Starr Center for Applied Economics, New York University.
  3. Richard Dennis & Federico Ravenna, 2007. "Learning and optimal monetary policy," Working Paper Series 2007-19, Federal Reserve Bank of San Francisco.
  4. Buiter,Willem H. & Marston,Richard C., 1986. "International Economic Policy Coordination," Cambridge Books, Cambridge University Press, number 9780521337809, November.
  5. Leitemo, Kai & Söderström, Ulf, 2008. "Robust monetary policy in a small open economy," Journal of Economic Dynamics and Control, Elsevier, vol. 32(10), pages 3218-3252, October.
  6. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
  7. A. Abel, 2010. "Asset prices under habit formation and catching up with the Jones," Levine's Working Paper Archive 1395, David K. Levine.
  8. Dennis, Richard & Söderström, Ulf, 2002. "How Important Is Precommitment for Monetary Policy?," Working Paper Series 139, Sveriges Riksbank (Central Bank of Sweden).
  9. Levin, Andrew T. & Williams, John C., 2003. "Robust monetary policy with competing reference models," Journal of Monetary Economics, Elsevier, vol. 50(5), pages 945-975, July.
  10. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
  11. Epstein, Larry G & Wang, Tan, 1994. "Intertemporal Asset Pricing Under Knightian Uncertainty," Econometrica, Econometric Society, vol. 62(2), pages 283-322, March.
  12. Richard Dennis & Kai Leitemo & Ulf Söderström, 2007. "Monetary policy in a small open economy with a preference for robustness," Working Paper Series 2007-04, Federal Reserve Bank of San Francisco.
  13. Lars Hansen & Thomas Sargent & Thomas Tallarini, . "Robust Permanent Income and Pricing," GSIA Working Papers 1997-51, Carnegie Mellon University, Tepper School of Business.
  14. Carl Walsh, 2003. "Speed Limit Policies: The Output Gap and Optimal Monetary Policy," American Economic Review, American Economic Association, vol. 93(1), pages 265-278, March.
  15. Smets, Frank & Wouters, Raf, 2002. "An estimated stochastic dynamic general equilibrium model of the euro area," Working Paper Series 0171, European Central Bank.
  16. Leitemo, Kai & Söderström, Ulf, 2005. "Robust monetary policy in a small open economy," Research Discussion Papers 20/2005, Bank of Finland.
  17. 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.
  18. Hans M. Amman & David A. Kendrick, . "Computational Economics," Online economics textbooks, SUNY-Oswego, Department of Economics, number comp1, December.
  19. Giordani, Paolo & Soderlind, Paul, 2004. "Solution of macromodels with Hansen-Sargent robust policies: some extensions," Journal of Economic Dynamics and Control, Elsevier, vol. 28(12), pages 2367-2397, December.
  20. Dennis, Richard, 2007. "Optimal Policy In Rational Expectations Models: New Solution Algorithms," Macroeconomic Dynamics, Cambridge University Press, vol. 11(01), pages 31-55, February.
  21. Anderson, Evan W. & McGrattan, Ellen R. & Hansen, Lars Peter & Sargent, Thomas J., 1996. "Mechanics of forming and estimating dynamic linear economies," Handbook of Computational Economics, in: H. M. Amman & D. A. Kendrick & J. Rust (ed.), Handbook of Computational Economics, edition 1, volume 1, chapter 4, pages 171-252 Elsevier.
  22. Alexei Onatski & Noah Williams, 2003. "Modeling Model Uncertainty," NBER Working Papers 9566, National Bureau of Economic Research, Inc.
  23. 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.
  24. repec:cup:macdyn:v:6:y:2002:i:1:p:111-44 is not listed on IDEAS
  25. Walsh, Carl E, 1995. "Optimal Contracts for Central Bankers," American Economic Review, American Economic Association, vol. 85(1), pages 150-67, March.
  26. Michael Woodford, 2010. "Robustly Optimal Monetary Policy with Near-Rational Expectations," American Economic Review, American Economic Association, vol. 100(1), pages 274-303, March.
  27. 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.
  28. Gino Cateau, 2006. "Guarding Against Large Policy Errors under Model Uncertainty," Staff Working Papers 06-13, Bank of Canada.
  29. Alexei Onatski & James H. Stock, 1999. "Robust monetary policy under model uncertainty in a small model of the U.S. economy," Proceedings, Federal Reserve Bank of San Francisco.
  30. Hansen, Lars Peter & Sargent, Thomas J. & Wang, Neng E., 2002. "Robust Permanent Income And Pricing With Filtering," Macroeconomic Dynamics, Cambridge University Press, vol. 6(01), pages 40-84, February.
  31. Giannoni, Marc P., 2002. "Does Model Uncertainty Justify Caution? Robust Optimal Monetary Policy In A Forward-Looking Model," Macroeconomic Dynamics, Cambridge University Press, vol. 6(01), pages 111-144, February.
  32. repec:cup:macdyn:v:6:y:2002:i:1:p:40-84 is not listed on IDEAS
  33. Noah Williams & Lars E.O. Svensson, 2007. "Bayesian and Adaptive Optimal Policy under Model Uncertainty," 2007 Meeting Papers 446, Society for Economic Dynamics.
  34. Hansen, Lars Peter & Sargent, Thomas J. & Turmuhambetova, Gauhar & Williams, Noah, 2006. "Robust control and model misspecification," Journal of Economic Theory, Elsevier, vol. 128(1), pages 45-90, May.
  35. Tillmann, Peter, 2009. "The stabilization bias and robust monetary policy delegation," Journal of Macroeconomics, Elsevier, vol. 31(4), pages 730-734, December.
  36. Kenneth Rogoff, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, Oxford University Press, vol. 100(4), pages 1169-1189.
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