Working Paper: CEPR ID: DP6331
Authors: Lars E. O. Svensson; Noah Williams
Abstract: We examine optimal and other monetary policies in a linear-quadratic setup with a relatively general form of model uncertainty, so-called Markov jump-linear-quadratic systems extended to include forward-looking variables and unobservable "modes." The form of model uncertainty our framework encompasses includes: simple i.i.d. model deviations; serially correlated model deviations; estimable regime-switching models; more complex structural uncertainty about very different models, for instance, backward- and forward-looking models; time-varying central-bank judgment about the state of model uncertainty; and so forth. We provide an algorithm for finding the optimal policy as well as solutions for arbitrary policy functions. This allows us to compute and plot consistent distribution forecasts - fan charts - of target variables and instruments. Our methods hence extend certainty equivalence and "mean forecast targeting" to more general certainty non-equivalence and "distribution forecast targeting."
Keywords: multiplicative uncertainty; optimal policy
JEL Codes: E42; E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| model uncertainty (D80) | optimal monetary policy decisions (E52) |
| Markov Jump Linear Quadratic model (C32) | account for model uncertainty (C59) |
| distribution of future target variables (C46) | effective policy-making (D78) |
| mean forecasts (C53) | suboptimal outcomes (I14) |
| optimal policy (C61) | probability distributions over modes of uncertainty (C46) |
| transition probabilities of the Markov process (C69) | probability distributions over modes of uncertainty (C46) |