The Limits of Monetary Policy Under Imperfect Knowledge

The results in the paper have two main implications for current monetary policy debate. First, the past recession is widely believed to be caused by a `demand' shock, lowering both the output-gap and inflation. However, despite the monetary stimulus provided by central banks in the form low interest rates from conventional and unconventional policies, the recovery in US and in other countries remains sluggish. Consequently monetary authorities have been criticized for `not doing enough'. This paper suggests that the observed gradual adjustment is not inconsistent with policy being set optimally once we take into account of market participants' uncertainty about economic fundamentals. Second, the paper offers an alternative rationale for gradualism in monetary policy even in normal times, as reflected by high interest smoothing coefficients that are usually found in estimated Taylor rules.