Inflation models, optimal monetary policy and uncertain unemployment dynamics: Evidence from the US and the euro area

This paper explores the role that model uncertainty plays in determining the effect of monetary policy shocks on unemployment dynamics in the euro area and the US. We specify a range of BVARs that differ in terms of variables, lag structure, and the way the inflation process is modelled. For each model the central bank sets the interest rate minimizing a loss function. Given this solution, we quantify the impact of a monetary policy shock on unemployment for each model, and measure the degree of uncertainty as represented by the dispersion of both the policy rule parameters and the impulse response functions between models. The comparative evidence from the US and the euro area data indicates that model uncertainty is indeed an important feature, and that a model combination strategy might be a valuable advise to policymakers.