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Model uncertainty, robust policies, and the value of commitment

  • Kenneth Kasa

Using results from the literature on H-control, this paper incorporates model uncertainty into Whiteman's (1986) frequency domain approach to stabilization policy. The derived policies guarantee a minimum performance level even in the worst of (a bounded set of) circumstances. ; For a given level of model uncertainty, robust H- policies are shown to be more 'activist' than Whiteman's H- policies in the sense that their impulse responses are larger. Robust policies also tend to be more autocorrelated. Consequently, the premium associated with being able to commit is greater under model uncertainty. Without commitment, the policymaker isn't able to (credibly) smooth his response to the degree that he would like. ; From a technical standpoint, a contribution of this paper is its analysis of robust control in a model featuring a forward-looking state transition equation, which arises from the fact that the private sector bases its decisions on expectations of future government policy. Existing applications of H- control in economics follow the engineering literature, and only consider backward-looking state transition equations. It is the forward-looking nature of the state transition equation that makes a frequency domain approach attractive.

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Paper provided by Federal Reserve Bank of San Francisco in its series Working Paper Series with number 99-14.

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Date of creation: 1999
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Handle: RePEc:fip:fedfwp:99-14
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  1. V. V. Chari & Patrick E. Kehoe, 1990. "Sustainable Plans and Mutual Default," IMF Working Papers 90/22, International Monetary Fund.
  2. Roberds, William, 1987. "Models of Policy under Stochastic Replanning," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 28(3), pages 731-55, October.
  3. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
  4. Hansen, Lars Peter & Sargent, Thomas J., 1980. "Formulating and estimating dynamic linear rational expectations models," Journal of Economic Dynamics and Control, Elsevier, vol. 2(1), pages 7-46, May.
  5. Oliner, Stephen D. & Rudebusch, Glenn D. & Sichel, Daniel, 1996. "The Lucas critique revisited assessing the stability of empirical Euler equations for investment," Journal of Econometrics, Elsevier, vol. 70(1), pages 291-316, January.
  6. McCallum, Bennett T, 1995. "Two Fallacies Concerning Central-Bank Independence," American Economic Review, American Economic Association, vol. 85(2), pages 207-11, May.
  7. V. V. Chari & Patrick J. Kehoe, 1989. "Sustainable plans," Staff Report 122, Federal Reserve Bank of Minneapolis.
  8. Christopher A. Sims, 1982. "Policy Analysis with Econometric Models," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 13(1), pages 107-164.
  9. Kenneth Kasa, 1994. "Optimal policy with limited commitment," Working Papers in Applied Economic Theory 94-16, Federal Reserve Bank of San Francisco.
  10. Taylor, John B, 1975. "Monetary Policy during a Transition to Rational Expectations," Journal of Political Economy, University of Chicago Press, vol. 83(5), pages 1009-21, October.
  11. Mark Salmon & Massimiliano Marcellino, 2001. "Robust Decision Theory and the Lucas Critique," Working Papers wp01-10, Warwick Business School, Finance Group.
  12. Stokey, Nancy L., 1991. "Credible public policy," Journal of Economic Dynamics and Control, Elsevier, vol. 15(4), pages 627-656, October.
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