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Parameters´ Instability, Model Uncertainty and Optimal Monetary Policy

Observed policy rates are smooth. Why should central banks smooth interest rates? We investigate if model uncertainty and parameters instability are a valid reason. We do so by implementing a novel ´´thick recursive modelling´´ approach within the framework of small structural macroeconomic models. At each point in time we estimate all models generated by the combinations of a base-set of $k$ observable regressors. Our econometric procedure delivers 2$^{k}$ models for aggregate demand and supply at any point in time. We compute optimal monetary policies for each of these specifications and then take their average as our benchmark optimal monetary policy. We then compare observed policy rates with those generated by the traditional ´´thin modelling´´ approach to optimal monetary policy and to our proposed ´´thick modelling´´ approach. Our results confirm the difficulty of recovering the deep parameters describing the preferences of the monetary policy makers from their observed behaviour. However, they also show that thick recursive modelling can, at least partially, explain the observed interest rate smoothness.

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Paper provided by IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University in its series Working Papers with number 196.

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Handle: RePEc:igi:igierp:196
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  1. Clarida, Richard & Galí, Jordi & Gertler, Mark, 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," CEPR Discussion Papers 1908, C.E.P.R. Discussion Papers.
  2. Söderström, Ulf, 1999. "Should central banks be more aggressive?," Working Paper Series 84, Sveriges Riksbank (Central Bank of Sweden).
  3. 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.
  4. Rudebusch, Glenn D & Svensson, Lars E O, 2000. "Eurosystem Monetary Targeting: Lessons from US Data," CEPR Discussion Papers 2522, C.E.P.R. Discussion Papers.
  5. Allan Timmermann & M. Hashem Pesaran, 1999. "A Recursive Modelling Approach to Predicting UK Stock Returns," FMG Discussion Papers dp322, Financial Markets Group.
  6. Gernot Doppelhofer & Ronald I. Miller & Xavier Sala-i-Martin, 2000. "Determinants of Long-Term Growth: A Bayesian Averaging of Classical Estimates (Bace) Approach," OECD Economics Department Working Papers 266, OECD Publishing.
  7. Pesaran, M Hashem & Timmermann, Allan, 1995. " Predictability of Stock Returns: Robustness and Economic Significance," Journal of Finance, American Finance Association, vol. 50(4), pages 1201-28, September.
  8. Hans M. Amman & David A. Kendrick, . "Computational Economics," Online economics textbooks, SUNY-Oswego, Department of Economics, number comp1.
  9. 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.
  10. Söderström, Ulf, 2000. "Monetary policy with uncertain parameters," Working Paper Series 0013, European Central Bank.
  11. Onatski, Alexei & Stock, James H., 2002. "Robust Monetary Policy Under Model Uncertainty In A Small Model Of The U.S. Economy," Macroeconomic Dynamics, Cambridge University Press, vol. 6(01), pages 85-110, February.
  12. Sack, Brian, 2000. "Does the fed act gradually? A VAR analysis," Journal of Monetary Economics, Elsevier, vol. 46(1), pages 229-256, August.
  13. Sack, Brian & Wieland, Volker, 2000. "Interest-rate smoothing and optimal monetary policy: a review of recent empirical evidence," Journal of Economics and Business, Elsevier, vol. 52(1-2), pages 205-228.
  14. Rudebusch, Glenn D., 2002. "Term structure evidence on interest rate smoothing and monetary policy inertia," Journal of Monetary Economics, Elsevier, vol. 49(6), pages 1161-1187, September.
  15. Granger, Clive W. J. & Jeon, Yongil, 2004. "Thick modeling," Economic Modelling, Elsevier, vol. 21(2), pages 323-343, March.
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