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Monetary Policy Attenuation As Robust Response To Misspecified Dynamics In A Forward Looking Model

Listed author(s):
  • Robert Tetlow, Peter von zur Muehlen

    (Board of Governors of the Federal Reserve System)

This paper explores Knightian model uncertainty about dynamic misspecification as a possible explanation of the considerable difference between estimated interest rate rules and optimal feedback descriptions of monetary policy. In the literature on robust control, Knightian uncertainty about a model's structure has been shown to induce the decision maker to become a robust Stackelberg leader playing against evil nature, that is, against an agent choosing uncertainty to maximize the leader's welfare losses. For an estimated forward looking model of the US economy, we find that rules designed to protect against the worst-case consequences of misspecified dynamics are less aggressive than either certainty-equivalent rules or robust rules. Rules that are robust against unmodeled dynamics also turn out to be good approximations of a rule estimated over recent history. The drawback of such attenuated policies is that when the system turns out to have been correctly specified, they may render the economy vulnerable to shocks at critical business cycle frequencies.

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2000 with number 302.

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Date of creation: 05 Jul 2000
Handle: RePEc:sce:scecf0:302
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CEF 2000, Departament d'Economia i Empresa, Universitat Pompeu Fabra, Ramon Trias Fargas, 25,27, 08005, Barcelona, Spain

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