Abstract: A standard result in the literature on monetary policy rules is that of
certainty equivalence: given the expected values of all the state
variables of the economy, policy should be set in a way that is
independent of all higher moments of those variables. Some exceptions to
this rule have been pointed out by Smets (1998), who restricts policy to
respond to only a limited subset of state variables, and by Orphanides
(1998), who restricts policy to respond to estimates of the state
variables that are biased. In contrast, this paper studies unrestricted,
fully optimal policy rules with optimal estimation of state variables.
The rules in this framework exhibit certainty equivalence with respect to
estimates of an unobserved, possibly complicated, state of the economy X,
but are not certaintyequivalent when 1) a signalextraction problem is
involved in the estimation of X, and 2) the optimal rule is expressed as
a reduced form that combines policymakers' estimation and policysetting
stages. In general, I show that it is optimal for policymakers to
attenuate their reaction coefficient on a variable about which
uncertainty has increased, while responding more aggressively to all
other variables, about which uncertainty hasn't changed.
Keywords: Signal extraction, certainty equivalence, monetary policy rules, Taylor rule
Full paper (335 KB PDF)
 Full paper (325 KB Postscript)
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Last update: June 30, 2000
