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Parameter Instability, Model Uncertainty and the Choice of Monetary Policy

Carlo Favero () and Fabio Milani ()

No 4909, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: This paper starts from the observation that parameter instability and model uncertainty are relevant problems for the analysis of monetary policy in small macroeconomic models. We propose to deal with these two problems by implementing a novel ‘thick recursive modelling’ approach. At each point in time we estimate all models generated by the combinations of a base-set of k observable regressors for aggregate demand and supply. We compute optimal monetary policies for all possible models and consider alternative ways of summarizing their distribution. Our main results show that thick recursive modelling delivers optimal policy rates that track the observed policy rates better than the optimal policy rates obtained under a constant parameter specification, with no role for model uncertainty.

Keywords: model uncertainty; optimal monetary policy; parameter instability (search for similar items in EconPapers)
JEL-codes: E44 E52 F41 (search for similar items in EconPapers)
Date: 2005-02
New Economics Papers: this item is included in nep-cba, nep-ecm and nep-mac
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