Robust monetary policy in a model with financial distress

Rafael Gerke, Felix Hammermann and Vivien Lewis

Journal of Macroeconomics, 2012, vol. 34, issue 2, 318-325

Abstract: We characterise optimal discretionary monetary policy responses to cost-push shocks and to financial distress in the presence of model uncertainty. Under robust control, the central bank reacts more aggressively to both types of shocks, and less to the lagged policy rate, than if the true model is known. We document how the objective to stabilise the policy instrument conflicts with the concern for robustness to model misspecification: the higher the weight on interest rate stabilisation in the loss function, the more the robust policy deviates from the optimal policy under rational expectations. Financial distress is akin to a contractionary demand shock and does not induce a policy trade-off; thus model uncertainty does not constrain monetary policy in the face of financial shocks.

Keywords: Optimal monetary policy; Discretion; Model uncertainty; Interest rate stabilisation; Robust control (search for similar items in EconPapers)
JEL-codes: E32 E44 E58 (search for similar items in EconPapers)
Date: 2012
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Working Paper: Robust Monetary Policy in a Model with Financial Distress (2011)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jmacro:v:34:y:2012:i:2:p:318-325

DOI: 10.1016/j.jmacro.2012.01.006

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