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Optimal monetary policy in a regime-switching economy

  • Fabrizio Zampolli

This paper is of interest for two reasons. First, it provides a simple algorithm for solving an optimal control problem in which the law of motion of the economy is a Markov regime-switching vector autoregression. Second, it applies this algorithm to study optimal monetary policy in a stylised small open economy model, which alternates randomly between two states: a `no-bubble' regime, in which the exchange rate fluctuates, in a stationary way, around its long-run equilibrium; and a `bubble' regime, in which the exchange rate (absent any offsetting impact of policy or exogenous shocks) increasingly deviates from it. We compute the optimal policy rule for this economy, as opposed to an optimised reaction function. This rule is regime-contingent in that policy response varies according to whether the economy is experiencing a bubble or not. The main results are as follows. First, while the optimal weights on output and inflation do not vary much between regimes, the optimal reaction to the asset price is highly dependent on the regime as well as the stochastic properties of the bubble. Second, uncertainty about the regime makes policy more cautious. Third, a policymaker uncertain about the true stochastic properties of the asset price tends to obtain a `robust' performance (i.e. minmax outcome) by responding little to the asset price. Finally, over-estimating the probability of an incipient bubble is generally more costly than under-estimating it

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2004 with number 166.

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Date of creation: 11 Aug 2004
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Handle: RePEc:sce:scecf4:166
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  1. Froot, Kenneth A & Obstfeld, Maurice, 1991. "Intrinsic Bubbles: The Case of Stock Prices," American Economic Review, American Economic Association, vol. 81(5), pages 1189-214, December.
  2. Stephen G. Cecchetti & Anil K Kashyap, 1995. "International Cycles," NBER Working Papers 5310, National Bureau of Economic Research, Inc.
  3. Andrew J. Filardo, 2001. "Should monetary policy respond to asset price bubbles? : some experimental results," Research Working Paper RWP 01-04, Federal Reserve Bank of Kansas City.
  4. Orphanides, Athanasios & Wieland, Volker, 2000. "Inflation zone targeting," European Economic Review, Elsevier, vol. 44(7), pages 1351-1387, June.
  5. Stephen G. Cecchetti & Hans Genberg & Sushil Wadhwani, 2002. "Asset Prices in a Flexible Inflation Targeting Framework," NBER Working Papers 8970, National Bureau of Economic Research, Inc.
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  7. Timothy Cogley & Thomas J. Sargent, 2005. "The conquest of US inflation: Learning and robustness to model uncertainty," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 8(2), pages 528-563, April.
  8. Charles Bean, 2003. "Asset prices, financial imbalances and monetary policy: are inflation targets enough?," BIS Working Papers 140, Bank for International Settlements.
  9. Ben Bernanke & Mark Gertler, 2000. "Monetary Policy and Asset Price Volatility," NBER Working Papers 7559, National Bureau of Economic Research, Inc.
  10. Meredith Beechey & Nargis Bharucha & Adam Cagliarini & David Gruen & Christopher Thompson, 2000. "A Small Model of the Australian Macroeconomy," RBA Research Discussion Papers rdp2000-05, Reserve Bank of Australia.
  11. Brock,W.A. & Durlauf,S.N. & West,K.D., 2003. "Policy evaluation in uncertain economic environments," Working papers 15, Wisconsin Madison - Social Systems.
  12. Ali Al-Nowaihi & Livio Stracca, 2003. "Behavioural Central Bank Loss Functions, Skewed Risks and Certainty Equivalence," Manchester School, University of Manchester, vol. 71(Supplemen), pages 21-38, 09.
  13. Fabio Milani, 2004. "Monetary Policy with a Wider Information Set: a Bayesian Model Averaging Approach," Macroeconomics 0401004, EconWPA.
  14. Bean, Charles, 1998. "The New UK Monetary Arrangements: A View from the Literature," Economic Journal, Royal Economic Society, vol. 108(451), pages 1795-1809, November.
  15. Ben S. Bernanke & Mark Gertler, 2001. "Should Central Banks Respond to Movements in Asset Prices?," American Economic Review, American Economic Association, vol. 91(2), pages 253-257, May.
  16. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  17. Thomas J. Sargent & LarsPeter Hansen, 2001. "Robust Control and Model Uncertainty," American Economic Review, American Economic Association, vol. 91(2), pages 60-66, May.
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