Working Paper: CEPR ID: DP4956
Authors: Keith Kuester; Volker Wieland
Abstract: In this paper, we examine the cost of insurance against model uncertainty for the euro area considering four alternative reference models, all of which are used for policy analysis at the ECB. We find that maximal insurance across this model range in terms of a Minimax policy comes at moderate costs in terms of lower expected performance. We extract priors that would rationalize the Minimax policy from a Bayesian perspective. These priors indicate that full insurance is strongly oriented towards the model with highest baseline losses. Furthermore, this policy is not as tolerant towards small perturbations of policy parameters as the Bayesian policy rule. We propose to strike a compromise and use preferences for policy design that allow for intermediate degrees of ambiguity-aversion. These preferences allow the specification of priors but also give extra weight to the worst uncertain outcomes in a given context.
Keywords: euro area; minimax; model uncertainty; monetary policy rules; robustness
JEL Codes: E52; E58; E61
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| maximal insurance against model uncertainty via minimax policy (D81) | lower expected performance (D29) |
| choice of model (C52) | outcomes of the policy (F68) |
| type of policy (G52) | robustness to parameter changes (C52) |