Working Paper: CEPR ID: DP9107
Authors: Athanasios Orphanides; Volker Wieland
Abstract: The complexity resulting from intertwined uncertainties regarding model misspecification and mismeasurement of the state of the economy defines the monetary policy landscape. Using the euro area as laboratory this paper explores the design of robust policy guides aiming to maintain stability in the economy while recognizing this complexity. We document substantial output gap mismeasurement and make use of a new model data base to capture the evolution of model specification. A simple interest rate rule is employed to interpret ECB policy since 1999. An evaluation of alternative policy rules across 11 models of the euro area confirms the fragility of policy analysis optimized for any specific model and shows the merits of model averaging in policy design. Interestingly, a simple difference rule with the same coefficients on inflation and output growth as the one used to interpret ECB policy is quite robust as long as it responds to current outcomes of these variables.
Keywords: complexity; ECB; financial crisis; model uncertainty; monetary policy; robust simple rules
JEL Codes: E50; E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| complexity of the economy (P19) | design and effectiveness of monetary policy (E52) |
| misestimation of the output gap (E23) | central bank's ability to stabilize the economy (E58) |
| simple interest rate rule (E43) | robust framework for interpreting ECB policy (E52) |
| simple difference rule (C20) | maintaining stability (C62) |
| model-specific optimizations (C52) | robust performance across different economic conditions (E32) |
| reliance on model-specific rules (C52) | significant macroeconomic fluctuations (E32) |