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Monetary Policy-making in the Presence of Knightian Uncertainty

  • Adam Cagliarini

    (Reserve Bank of Australia)

  • Alexandra Heath

    (Reserve Bank of Australia)

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    This paper explores the extent to which Knightian uncertainty can explain features of interest rate paths observed in practice that are not generally replicated by models of optimal monetary policy. Interest rates tend to move in a sequence of steps in a given direction, or remain constant for some time, rather than experiencing the frequent reversals that commonly arise from optimal policy simulations. We categorise the types of uncertainty that have been explored to date in terms of the decision-making behaviour they imply. From this, we suggest a more intuitively appealing formulation of Knightian uncertainty than the one that has previously been used in the analysis of monetary policy. Within a very simple optimal control problem, we show that our preferred formalisation is consistent with interest rate paths with periods of no change. This suggests that the presence of Knightian uncertainty may explain some features of monetary policy-makers’ behaviour.

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    File URL: http://www.rba.gov.au/publications/rdp/2000/pdf/rdp2000-10.pdf
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    Paper provided by Reserve Bank of Australia in its series RBA Research Discussion Papers with number rdp2000-10.

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    Date of creation: Dec 2000
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    Handle: RePEc:rba:rbardp:rdp2000-10
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    1. Svensson, L-E-O, 1997. "Inflation Targeting : Some Extensions," Papers 625, Stockholm - International Economic Studies.
    2. Arturo Estrella & Frederic Mishkin, 1998. "Rethinking the role of NAIRU in monetary policy: implications of model formulation and uncertainty," Research Paper 9806, Federal Reserve Bank of New York.
    3. Geoffrey Shuetrim & Christopher Thompson, 1999. "The Implications of Uncertainty for Monetary Policy," RBA Research Discussion Papers rdp1999-10, Reserve Bank of Australia.
    4. 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.
    5. David Schmeidler, 1989. "Subjective Probability and Expected Utility without Additivity," Levine's Working Paper Archive 7662, David K. Levine.
    6. Ball, Laurence, 1999. "Efficient Rules for Monetary Policy," International Finance, Wiley Blackwell, vol. 2(1), pages 63-83, April.
    7. Sack, Brian, 2000. "Does the fed act gradually? A VAR analysis," Journal of Monetary Economics, Elsevier, vol. 46(1), pages 229-256, August.
    8. LeRoy, Stephen F & Singell, Larry D, Jr, 1987. "Knight on Risk and Uncertainty," Journal of Political Economy, University of Chicago Press, vol. 95(2), pages 394-406, April.
    9. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
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