Model uncertainty and monetary policy
By: Richard Dennis
Contributors: Federal Reserve Bank of San Francisco
Series: FRBSF working paper -- 2007-09; FRBSF working paper (Online) -- #2007-09.
Publisher: Federal Reserve Bank of San Francisco
Published: 2007
Place of publication: San Francisco]
Language: eng
Format: [electronic resource] /
Description: Model uncertainty has the potential to change importantly how monetary policy should  be conducted, making it an issue that central banks cannot ignore. In this paper, I use  a standard new Keynesian business cycle model to analyze the behavior of a central bank  that conducts policy with discretion while fearing that its model is misspecified. I begin by  showing how to solve linear-quadratic robust Markov-perfect Stackelberg problems where  the leader fears that private agents form expectations using the misspecified model. Next,  I exploit the connection between robust control and uncertainty aversion to present and  interpret my results in terms of the distorted beliefs held by the central bank, households,  and firms. My main results are as follows. First, the central bank's pessimism leads  it to forecast future outcomes using an expectations operator that, relative to rational  expectations, assigns greater probability to extreme inflation and consumption outcomes.  Second, the central bank's skepticism about its model causes it to move forcefully to  stabilize inflation following shocks. Finally, even in the absence of misspecification, policy  loss can be improved if the central bank implements a robust policy.
Notes: Title from PDF file (viewed on Sept. 13, 2007).

"May 2007."

Includes bibliographical references.

Also available in print.

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Mode of access: World Wide Web.