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Model Uncertainty and Monetary Policy

  • Richard Dennis

    ()

    (Federal Reserve Bank of San Francisco)

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 misspecified. 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 mitigating 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 misspecification leads it to forecast future outcomes under the belief 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 inflation will be more closely stabilized, 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://www.ncer.edu.au/papers/documents/NCER_WpNo30Aug08.pdf
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Paper provided by National Centre for Econometric Research in its series NCER Working Paper Series with number 30.

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Length: 30 pages
Date of creation: 10 Aug 2008
Date of revision:
Handle: RePEc:qut:auncer:2008-19
Contact details of provider: Phone: 07 3138 5066
Fax: 07 3138 1500
Web page: http://www.ncer.edu.au

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  1. Richard Dennis & Kai Leitemo & Ulf Soderstrom, 2006. "Methods for Robust Control," Working Papers 307, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  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. 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.
  4. 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.
  5. 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.
  6. Michael Woodford, 2005. "Robustly Optimal Monetary Policy with Near Rational Expectations," NBER Working Papers 11896, National Bureau of Economic Research, Inc.
  7. 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.
  8. Richard Dennis & Ulf Soderstrom, 2002. "How important is precommitment for monetary policy?," Working Paper Series 2002-10, Federal Reserve Bank of San Francisco.
  9. Leitemo , Kai & Söderström , Ulf, 2005. "Robust monetary policy in a small open economy," Research Discussion Papers 20/2005, Bank of Finland.
  10. Walsh, Carl E, 1995. "Optimal Contracts for Central Bankers," American Economic Review, American Economic Association, vol. 85(1), pages 150-67, March.
  11. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
  12. Andrew B. Abel, 1990. "Asset Prices under Habit Formation and Catching up with the Joneses," NBER Working Papers 3279, National Bureau of Economic Research, Inc.
  13. Alexei Onatski & Noah Williams, 2003. "Modeling Model Uncertainty," NBER Working Papers 9566, National Bureau of Economic Research, Inc.
  14. 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.
  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. 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.
  17. 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.
  18. Hans M. Amman & David A. Kendrick, . "Computational Economics," Online economics textbooks, SUNY-Oswego, Department of Economics, number comp1.
  19. Willem H. Buiter & Richard C. Marston, 1985. "International Economic Policy Coordination," NBER Books, National Bureau of Economic Research, Inc, number buit85-1, August.
  20. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Working Paper Series WP-01-08, Federal Reserve Bank of Chicago.
  21. Richard Dennis & Federico Ravenna, 2007. "Learning and optimal monetary policy," Working Paper Series 2007-19, Federal Reserve Bank of San Francisco.
  22. Lars Hansen & Thomas Sargent & Thomas Tallarini, . "Robust Permanent Income and Pricing," GSIA Working Papers 1997-51, Carnegie Mellon University, Tepper School of Business.
  23. Epstein, Larry G & Wang, Tan, 1994. "Intertemporal Asset Pricing Under Knightian Uncertainty," Econometrica, Econometric Society, vol. 62(2), pages 283-322, March.
  24. repec:cup:macdyn:v:6:y:2002:i:1:p:111-44 is not listed on IDEAS
  25. Alexei Onatski & James H. Stock, 2000. "Robust Monetary Policy Under Model Uncertainty in a Small Model of the U.S. Economy," NBER Working Papers 7490, National Bureau of Economic Research, Inc.
  26. Svensson, Lars E. O. & Williams, Noah, 2006. "Bayesian and adaptive optimal policy under model uncertainty," CFS Working Paper Series 2007/11, Center for Financial Studies (CFS).
  27. Carl Walsh, 2001. "Speed Limit Policies: The Output Gap and Optimal Monetary Policy," CESifo Working Paper Series 609, CESifo Group Munich.
  28. 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.
  29. Dennis, Richard, 2007. "Optimal Policy In Rational Expectations Models: New Solution Algorithms," Macroeconomic Dynamics, Cambridge University Press, vol. 11(01), pages 31-55, February.
  30. repec:cup:macdyn:v:6:y:2002:i:1:p:40-84 is not listed on IDEAS
  31. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, vol. 100(4), pages 1169-89, November.
  32. 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.
  33. Gino Cateau, 2006. "Guarding Against Large Policy Errors under Model Uncertainty," Working Papers 06-13, Bank of Canada.
  34. Tillmann, Peter, 2009. "The stabilization bias and robust monetary policy delegation," Journal of Macroeconomics, Elsevier, vol. 31(4), pages 730-734, December.
  35. Robert J. Tetlow & Peter von zur Muehlen, 2000. "Robust monetary policy with misspecified models: does model uncertainty always call for attenuated policy?," Finance and Economics Discussion Series 2000-28, Board of Governors of the Federal Reserve System (U.S.).
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