Optimal monetary policy in a micro-founded model with parameter uncertainty

Takeshi Kimura and Takushi Kurozumi

No 2003-67, Finance and Economics Discussion Series from Board of Governors of the Federal Reserve System (U.S.)

Abstract: In this paper, we structurally model uncertainty with a micro-founded model, and investigate its implications for optimal monetary policy. Uncertainty about deep parameters of the model implies that the central bank simultaneously faces both uncertainty about the structural dynamic equations and about the social loss function. Considering both uncertainties with cross-parameter restrictions based on the micro-foundations of the model, we use Bayesian methods to determine the optimal monetary policy that minimizes the expected loss. Our analysis shows how uncertainty can lead the central bank to pursue a more aggressive monetary policy, overturning Brainard's common wisdom. As the degree of uncertainty about inflation dynamics increases, the central bank should place much more weight on price stability, and should respond to shocks more aggressively. In addition, when the central bank is uncertain about output dynamics, an aggressive policy response can be justified by the positive correlation between policy multiplier and transmission of natural rate of interest shock as well as the effect of loss-function uncertainty. We also show that combining a more aggressive policy response with a highly inertial interest rate policy reduces Bayesian risk.

Keywords: Monetary policy; Econometric models (search for similar items in EconPapers)
Date: 2003
New Economics Papers: this item is included in nep-mac and nep-mon
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Citations: View citations in EconPapers (12)

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Journal Article: Optimal monetary policy in a micro-founded model with parameter uncertainty (2007)
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