Optimal monetary policy in a regime-switching economy
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
|Date of creation:||11 Aug 2004|
|Date of revision:|
|Contact details of provider:|| Web page: http://comp-econ.org/|
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Ben Bernanke & Mark Gertler, 2000.
"Monetary Policy and Asset Price Volatility,"
NBER Working Papers
7559, National Bureau of Economic Research, Inc.
- Ben Bernanke & Mark Gertler, 1999. "Monetary policy and asset price volatility," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 77-128.
- Ben Bernanke & Mark Gertler, 1999. "Monetary policy and asset price volatility," Economic Review, Federal Reserve Bank of Kansas City, issue Q IV, pages 17-51.
- William A. Brock & Steven N. Durlauf & Kenneth D. West, 2003.
"Policy Evaluation in Uncertain Economic Environments,"
NBER Working Papers
10025, National Bureau of Economic Research, Inc.
- William A. Brock & Steven N. Durlauf & Kenneth D. West, 2003. "Policy Evaluation in Uncertain Economic Environments," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 235-322.
- Brock,W.A. & Durlauf,S.N. & West,K.D., 2003. "Policy evaluation in uncertain economic environments," Working papers 15, Wisconsin Madison - Social Systems.
- 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.
- 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.
- 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.
- Cogley, Timothy & Sargent, Thomas J., 2005. "The conquest of U.S. inflation: learning and robustness to model uncertainty," Working Paper Series 0478, European Central Bank.
- 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.
- Fabio Milani, 2008.
"Monetary Policy With A Wider Information Set: A Bayesian Model Averaging Approach,"
Scottish Journal of Political Economy,
Scottish Economic Society, vol. 55(1), pages 1-30, 02.
- Fabio Milani, 2004. "Monetary Policy with a Wider Information Set: a Bayesian Model Averaging Approach," Macroeconomics 0401004, EconWPA.
- Orphanides, Athanasios & Wieland, Volker, 2000.
"Inflation zone targeting,"
European Economic Review,
Elsevier, vol. 44(7), pages 1351-1387, June.
- Charles Bean, 2003.
"Asset Prices, Financial Imbalances and Monetary Policy: Are Inflation Targets Enough?,"
RBA Annual Conference Volume,
in: Anthony Richards & Tim Robinson (ed.), Asset Prices and Monetary Policy
Reserve Bank of Australia.
- Charles Bean, 2003. "Asset prices, financial imbalances and monetary policy: are inflation targets enough?," BIS Working Papers 140, Bank for International Settlements.
- Stephen G. Cecchetti & Anil K Kashyap, 1995.
NBER Working Papers
5310, National Bureau of Economic Research, Inc.
- 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.
- Thomas J. Sargent & LarsPeter Hansen, 2001. "Robust Control and Model Uncertainty," American Economic Review, American Economic Association, vol. 91(2), pages 60-66, May.
- Charles A.E. Goodhart, 2001. "Monetary transmission lags and the formulation of the policy decision on interest rates," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 165-186.
- 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.
- 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.
- 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.
- 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.
When requesting a correction, please mention this item's handle: RePEc:sce:scecf4:166. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christopher F. Baum)
If references are entirely missing, you can add them using this form.