Working Paper: CEPR ID: DP4909
Authors: Carlo A. Favero; Fabio Milani
Abstract: This paper starts from the observation that parameter instability and model uncertainty are relevant problems for the analysis of monetary policy in small macroeconomic models. We propose to deal with these two problems by implementing a novel ?thick recursive modelling? approach. At each point in time we estimate all models generated by the combinations of a base-set of k observable regressors for aggregate demand and supply. We compute optimal monetary policies for all possible models and consider alternative ways of summarizing their distribution. Our main results show that thick recursive modelling delivers optimal policy rates that track the observed policy rates better than the optimal policy rates obtained under a constant parameter specification, with no role for model uncertainty.
Keywords: Model Uncertainty; Optimal Monetary Policy; Parameter Instability
JEL Codes: E44; E52; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| parameter instability and model uncertainty (C51) | optimal monetary policy formulation (E60) |
| traditional thin modeling (C52) | optimal monetary policy formulation (E60) |
| thick recursive modeling (C59) | optimal monetary policy representation (E19) |
| model uncertainty (D80) | variations in optimal policy outcomes (D78) |
| average or weighted average of optimal policies (C61) | robust monetary policy formulation (E60) |