Working Paper: CEPR ID: DP5071
Authors: Kai Leitemo; Ulf Sderstrm
Abstract: This paper studies how a central bank?s preference for robustness against model misspecification affects the design of monetary policy in a New-Keynesian model of a small open economy. Due to the simple model structure, we are able to solve analytically for the optimal robust policy rule, and we separately analyse the effects of robustness against misspecification concerning the determination of inflation, output and the exchange rate. We show that an increased central bank preference for robustness makes monetary policy respond more aggressively or more cautiously to shocks, depending on the type of shock and the source of misspecification.
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 (D01) | more aggressive monetary policy responses (E63) |
| increased preference for robustness (D01) | more cautious monetary policy responses (E63) |
| increased uncertainty about the persistence of inflation (E31) | more aggressive monetary policy (E63) |
| increased uncertainty about other parameters (D89) | more cautious monetary policy (E63) |
| robustness to misspecification in the Phillips curve (C54) | inefficiently high output variability (D29) |
| robustness to misspecification in the exchange rate equations (C51) | inefficiently high output variability (D29) |
| robustness against misspecification in the output equation (C51) | higher inflation variability (E31) |
| central bank's preference for robustness (E58) | optimal interest rate rule influenced by model misspecification (E43) |
| central bank's preference for robustness (E58) | optimal output-inflation tradeoff remains unaffected (E31) |