Monetary Policy with Ambiguity Averse Agents

Riccardo M. Masolo and Francesca Monti

No 1506, Discussion Papers from Centre for Macroeconomics (CFM)

Abstract: We study a prototypical new-Keynesian model in which agents are averse to ambiguity, and where the ambiguity regards the monetary policy rule. We show that ambiguity has important effects even in steady state, as uncertainty about the policymaker’s response function affects the rest of the model via the consumption-saving decision. A reduction in ambiguity - e.g. due to credible monetary policy actions and communications - results in a fall in inflation and the policy rate, and an increase in welfare. Moreover while, absent ambiguity, the policymaker’s actual responsiveness to inflation does not matter as long as the Taylor principle is satisfied, in the face of ambiguity the exact degree to which the central bank responds to inflation regains importance. Indeed, a high degree of responsiveness to inflation mitigates the welfare costs of ambiguity. We also present various results regarding the optimal choice of an inflation target, both when ambiguity is given and when assuming the policymaker can affect ambiguity with increased transparency and communications.

Keywords: Ambiguity; Aversion; Monetary Policy (search for similar items in EconPapers)
JEL-codes: D84 E31 E43 E52 E58 (search for similar items in EconPapers)
Pages: 31 pages
Date: 2015-03
New Economics Papers: this item is included in nep-cba, nep-mac, nep-mon and nep-upt
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Working Paper: Monetary policy with ambiguity averse agents (2015)
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Persistent link: https://EconPapers.repec.org/RePEc:cfm:wpaper:1506

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