Working Paper: CEPR ID: DP6067
Authors: Richard Dennis; Kai Leitemo; Ulf Soderstrom
Abstract: We use robust control techniques to study the effects of model uncertainty on monetary policy in an estimated, semi-structural, small-open-economy model of the U.K. Compared to the closed economy, the presence of an exchange rate channel for monetary policy not only produces new trade-offs for monetary policy, but it also introduces an additional source of specification errors. We find that exchange rate shocks are an important contributor to volatility in the model, and that the exchange rate equation is particularly vulnerable to model misspecification, along with the equation for domestic inflation. However, when policy is set with discretion, the cost of insuring against model misspecification appears reasonably small.
Keywords: Model Misspecification; Model Uncertainty; Robust Control
JEL Codes: E52; E61; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| exchange rate shocks (F31) | domestic inflation (E31) |
| exchange rate shocks (F31) | output (C67) |
| model misspecification (C52) | volatility in monetary policy outcomes (E61) |
| robust policy (E60) | mitigate adverse outcomes from model errors (C52) |
| specification errors in inflation equation (E31) | challenges for stabilization (E63) |
| robust policy response to inflation shocks (E63) | increased volatility in output (E39) |
| exchange rate equation (F31) | complications in monetary policy decisions (E52) |