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Robust monetary policy with misspecified models: does model uncertainty always call for attenuated policy?

  • Robert J. Tetlow
  • Peter von zur Muehlen

This paper explores Knightian model uncertainty as a possible explanation of the considerable difference between estimated interest rate rules and optimal feedback descriptions of monetary policy. We focus on two types of uncertainty: (i) unstructured model uncertainty reflected in additive shock error processes that result from omitted-variable misspecifications, and (ii) structured model uncertainty, where one or more parameters are identified as the source of misspecification. For an estimated forward-looking model of the U.S. economy, we find that rules that are robust against uncertainty, the nature of which is unspecifiable, or against one-time parametric shifts, are more aggressive than the optimal linear quadratic rule. However, policies designed to protect the economy against the worst-case consequences of misspecified dynamics are less aggressive and turn out to be good approximations of the estimated rule. A possible drawback of such policies is that the losses incurred from protecting against worst-case scenarios are concentrated among the same business cycle frequencies that normally occupy the attention of policymakers.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2000-28.

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Date of creation: 2000
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Handle: RePEc:fip:fedgfe:2000-28
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