Optimal monetary policy for a pessimistic central bank

Paolo Vitale

Journal of Macroeconomics, 2018, vol. 58, issue C, 39-59

Abstract: We consider the impact of pessimism on monetary policy within a model with backward-looking expectations and persistence in the dynamics of output and inflation. Pessimistic monetary authorities behave as if they believed that the worst economic conditions were very likely and move the policy instrument to hedge against their negative consequences. With respect to their risk-neutral counterparts, they apply a more aggressive Taylor rule, reducing the inflation rate volatility. The impact of pessimism on monetary policy is magnified by economic uncertainty. A calibration exercise for the U.S. economy confirms the relevance of pessimism as it shows that pessimistic monetary authorities react to a one-standard-deviation supply shock moving the policy instrument by about one percent more than their risk-neutral counterparts. Our conclusions also hold when the monetary authorities observe inflation and output with a time lag.

Keywords: Monetary policy; Pessimism; Discounted linear exponential quadratic Gaussian (search for similar items in EconPapers)
JEL-codes: C61 E52 E58 (search for similar items in EconPapers)
Date: 2018
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jmacro:v:58:y:2018:i:c:p:39-59

DOI: 10.1016/j.jmacro.2018.08.005

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