Working Paper: CEPR ID: DP3811
Authors: Volker Wieland
Abstract: Inflation-targeting central banks have only imperfect knowledge about the effect of policy decisions on inflation. An important source of uncertainty is the relationship between inflation and unemployment. This Paper studies the optimal monetary policy in the presence of uncertainty about the natural unemployment rate, the short-run inflation-unemployment trade-off and the degree of inflation persistence in a simple macroeconomic model, which incorporates rational learning by the central bank as well as private sector agents. Two conflicting motives drive the optimal policy. In the static version of the model, uncertainty provides a motive for the policymaker to move more cautiously than they would if they knew the true parameters. In the dynamic version, uncertainty also motivates an element of experimentation in policy. I find that the optimal policy that balances the cautionary and activist motives typically exhibits gradualism, that is, it still remains less aggressive than a policy that disregards parameter uncertainty. Exceptions occur when uncertainty is very high and inflation close to target.
Keywords: Inflation targeting; Monetary policy; Natural unemployment rate; Optimal learning; Parameter uncertainty
JEL Codes: C61; D80; E24; E52
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Uncertainty about the natural unemployment rate (J64) | Cautious policymaking (E60) |
| Cautious policymaking (E60) | Gradualism (O40) |
| High uncertainty (D89) | More aggressive monetary policy response (E63) |
| Rational expectations (D84) | Less aggressive responses compared to certainty-equivalent policy (D81) |
| Monetary policy (E52) | Inflation (E31) |
| Monetary policy (E52) | Unemployment (J64) |