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Uncertainty about the Persistence of Periods with Large Price Shocks and the Optimal Reaction of the Monetary Authority

Author

Listed:
  • Gonzalez F.
  • Rodriguez A.

    () (Economic Studies Division Bank of Mexico)

  • Gonzalez-Garcia J.R.

Abstract

Uncertainty about the persistence of periods characterized by large price shocks is an important aspect of monetary policy. This type of uncertainty posed some difficulties for central banks in 2004. This paper formalizes the treatment of this type of uncertainty by solving an optimal control problem in which the economy randomly alternates between two regimes characterized by different magnitudes of price shocks. By using an open economy model, we find that the optimal policy rule is both regime-contingent and robust. In particular, we find that: a) the optimal reaction of the interest rate is dependent on both the current regime and on the difference in the magnitude of the shocks between regimes; b) the alternation between regimes leads to more aggressive policy reactions with respect to inflation and the second lag of the real exchange rate; and c) after a robust selection of transition probabilities, the min-max probability of switching to the regime with large price shocks increases when such regime is more harmful. In general, cautious behavior renders smaller losses than recklessness for the central bank. This result argues in favor of caution over recklessness in the formulation of monetary policy when there is uncertainty about the persistence of periods with large price shocks

Suggested Citation

  • Gonzalez F. & Rodriguez A. & Gonzalez-Garcia J.R., 2005. "Uncertainty about the Persistence of Periods with Large Price Shocks and the Optimal Reaction of the Monetary Authority," Computing in Economics and Finance 2005 402, Society for Computational Economics.
  • Handle: RePEc:sce:scecf5:402
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    File URL: http://repec.org/sce2005/up.2461.1107215202.pdf
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    References listed on IDEAS

    as
    1. Laurence M. Ball, 1999. "Policy Rules for Open Economies," NBER Chapters,in: Monetary Policy Rules, pages 127-156 National Bureau of Economic Research, Inc.
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    4. Carl E. Walsh, 2004. "Precautionary policies," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue feb.13.
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    Cited by:

    1. Andrew P Blake & Fabrizio Zampolli, 2006. "Optimal monetary policy in Markov-switching models with rational expectations agents," Bank of England working papers 298, Bank of England.

    More about this item

    Keywords

    monetary policy; Markov regime-switching; optimal control; robustness; model uncertainty; inflation targeting;

    JEL classification:

    • C6 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit

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