Doubts about the Model and Optimal Policy

Anastasios Karantounias

No 2020-12, FRB Atlanta Working Paper from Federal Reserve Bank of Atlanta

Abstract: This paper analyzes optimal policy in setups where both the leader and the follower have doubts about the probability model of uncertainty. I illustrate the methodology in two environments: a) an industry populated with a large firm and many small firms in a competitive fringe, where both types of firms doubt the probability model of demand shocks, and b) a general equilibrium economy, where a policymaker taxes linearly the labor income of a representative household in order to finance an exogenous stream of stochastic spending shocks. The policymaker can distrust the probability model of spending shocks more, the same, or less than the household. Whenever there are doubts about the model, cautious agents form endogenous worst-case beliefs by assigning high probability on low profitability or low-utility events. There are two forces that shape optimal policy results: the manipulation of the endogenous beliefs of the follower to the benefit of the leader, and the discrepancy (if any) in the pessimistic beliefs between the leader and the follower. Depending on the application, the leader may amplify or mitigate the worst-case beliefs of the follower.

Keywords: model uncertainty; ambiguity aversion; multiplier preferences; misspecification; robustness; martingale; monopolist; competitive fringe; demand uncertainty; Ramsey taxation (search for similar items in EconPapers)
JEL-codes: D80 E62 H21 H63 (search for similar items in EconPapers)
Pages: 86
Date: 2020-07-31
New Economics Papers: this item is included in nep-dge, nep-mac, nep-mic, nep-pbe and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (9)

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Related works:
Journal Article: Doubts about the model and optimal policy (2023)
Working Paper: Doubts about the model and optimal policy (2023)
Working Paper: Doubts about the model and optimal policy (2023)
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedawp:88478

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DOI: 10.29338/wp2020-12

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