Uncertainty about the Persistence of Periods with Large Price Shocks and the Optimal Reaction of the Monetary Authority

Gonzalez F., Rodriguez A. () and Gonzalez-Garcia J.R.
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Rodriguez A.: Economic Studies Division Bank of Mexico
Authors registered in the RePEc Author Service: Fidel Gonzalez ()

No 402, Computing in Economics and Finance 2005 from Society for Computational Economics

Abstract: Uncertainty about the persistence of periods characterized by large price shocks is an important aspect of monetary policy. This type of uncertainty posed some difficulties for central banks in 2004. This paper formalizes the treatment of this type of uncertainty by solving an optimal control problem in which the economy randomly alternates between two regimes characterized by different magnitudes of price shocks. By using an open economy model, we find that the optimal policy rule is both regime-contingent and robust. In particular, we find that: a) the optimal reaction of the interest rate is dependent on both the current regime and on the difference in the magnitude of the shocks between regimes; b) the alternation between regimes leads to more aggressive policy reactions with respect to inflation and the second lag of the real exchange rate; and c) after a robust selection of transition probabilities, the min-max probability of switching to the regime with large price shocks increases when such regime is more harmful. In general, cautious behavior renders smaller losses than recklessness for the central bank. This result argues in favor of caution over recklessness in the formulation of monetary policy when there is uncertainty about the persistence of periods with large price shocks

Keywords: monetary policy; Markov regime-switching; optimal control; robustness; model uncertainty; inflation targeting (search for similar items in EconPapers)
JEL-codes: C6 E5 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
Date: 2005-11-11
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