Model Uncertainty, Optimal Monetary Policy and the Preferences of the Fed

This paper proposes a general method based on a property of zero-sum two-player games to derive robust optimal monetary policy rules—the best rules among those that yield an acceptable performance in a specified range of models—when the true model is unknown and model uncertainty is viewed as uncertainty about parameters of the structural model. The method is applied to characterize robust optimal Taylor rules in a simple forward-looking macroeconomic model that can be derived from first principles. Although it is commonly believed that monetary policy should be less responsive when there is parameter uncertainty, we show that robust optimal Taylor rules prescribe in general a stronger response of the interest rate to fluctuations in inflation and the output gap than is the case in the absence of uncertainty. Thus model uncertainty does not necessarily justify a relatively small response of actual monetary policy.

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A Bayesian Approach to Optimal Monetary Policy with Parameter and Model Uncertainty

SSRN Electronic Journal ◽

10.2139/ssrn.1786583 ◽

2011 ◽

Cited By ~ 3

Author(s):

Timothy Cogley ◽

Bianca De Paoli ◽

Christian Matthes ◽

Kalin Nikolov ◽

Tony Yates

Keyword(s):

Monetary Policy ◽

Bayesian Approach ◽

Model Uncertainty ◽

Optimal Monetary Policy

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Robust monetary policy in a currency union

Panoeconomicus ◽

10.2298/pan1202185k ◽

2012 ◽

Vol 59 (2) ◽

pp. 185-199

Author(s):

Olga Kuznetsova

Keyword(s):

Monetary Policy ◽

Central Bank ◽

Model Uncertainty ◽

Currency Union ◽

Optimal Monetary Policy ◽

Economic Shocks ◽

Worst Case ◽

Attenuation Effect ◽

Optimal Reaction ◽

Country Specific

A great number of recent researches have found importance of country specific shocks for optimal monetary policy construction in the context of a currency union. This however has been almost completely overlooked by the analysis of optimal monetary policy under model uncertainty. The main purpose of our work is to fill this gap. By using a model of a two-country currency union with sticky prices, we have derived robust monetary policy that works reasonably well even in the worst case of model perturbations. We find some anti-attenuation effect of uncertainty, and show that the central bank?s optimal reaction to economic shocks becomes more aggressive with an increase in the extent of misspecification.

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