Abstract: This paper explores Knightian model uncertainty as a possible
explanation of the considerable difference between estimated
interest rate rules and optimal feedback descriptions of monetary policy.
We focus on two types of uncertainty: (i) unstructured model uncertainty
reflected in additive shock error processes that result from
omitted-variable misspecifications, and (ii) structured model
uncertainty, where one or more parameters are identified as the
source of misspecification. For an estimated forward-looking model
of the U.S. economy, we find that rules that are robust against
uncertainty, the nature of which is unspecifiable, or against one-time
parametric shifts, are more aggressive than the optimal linear
quadratic rule. However, policies designed to protect the economy
against the worst-case consequences of misspecified dynamics
are less aggressive and turn out to be good approximations of the estimated
rule. A possible drawback of such policies is that the losses incurred from
protecting against worst-case scenarios are concentrated among the same
business cycle frequencies that normally occupy the attention of
policymakers.
Keywords: Model uncertainty, robust control, monetary policy, Stackelberg games.
Full paper (444 KB PDF)
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Last update: May 31, 2000
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