Working Paper: CEPR ID: DP4805
Authors: Kai Leitemo; Ulf Söderström
Abstract: We study the effects of model uncertainty in a simple New-Keynesian model using robust control techniques. Due to the simple model structure, we are able to find closed-form solutions for the robust control problem, analysing both instrument rules and targeting rules under different timing assumptions. In all cases but one, an increased preference for robustness makes monetary policy respond more aggressively to cost shocks but leaves the response to demand shocks unchanged. As a consequence, inflation is less volatile and output is more volatile than under the non-robust policy. Under one particular timing assumption, however, increasing the preference for robustness has no effect on the optimal targeting rule (nor on the economy).
Keywords: Knightian uncertainty; Minmax policies; Model uncertainty; Robust control
JEL Codes: E52; E58; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Increased preference for robustness (D81) | More aggressive monetary policy response to cost shocks (E63) |
| Increased preference for robustness (D81) | Response to demand shocks unchanged (E39) |
| More aggressive monetary policy response to cost shocks (E63) | Less volatile inflation (E31) |
| More aggressive monetary policy response to cost shocks (E63) | More volatile output (C69) |
| Nash equilibrium timing assumption (C72) | Optimal targeting rule unaffected by robustness preference (D80) |
| Nash equilibrium timing assumption (C72) | Optimal instrument rule reflects robustness preference (D80) |