The Impact of Uncertainty on Monetary Policy Rules in the UK

Christopher Martin and Costas Milas

No KERP 2006/09, Keele Economics Research Papers from Centre for Economic Research, Keele University

Abstract: Although policymakers and commentators have repeatedly stressed the impact of uncertainty about the true state of the economy on the setting of interest rates, the academic literature has largely ignored this issue. This paper provides a theoretical analysis of how uncertainty about the true state of the economy affects optimal monetary policy rules and presents empirical evidence using data for the UK since the introduction of inflation targets in October 1992. We find that the impact of inflation on interest rates is smaller when inflation is more uncertain and larger when the output gap is more uncertain; we also find that the impact of the output gap is smaller when the output gap is more uncertain. We also find that uncertainty has reduced the volatility but has not affected the average value of interest rates.

Keywords: Monetary policy; Uncertainty. (search for similar items in EconPapers)
JEL-codes: C51 C52 E52 E58 (search for similar items in EconPapers)
Pages: 28 pages
Date: 2006-06
New Economics Papers: this item is included in nep-cba, nep-mac, nep-mon and nep-pke
Note: This paper is a substantially revised and updated version of our paper "Uncertainty and UK Monetary Policy" (KERP 2005/11). We thank Virginie Boinet, Jerry Coakley, Denise Osborn, Theo Panagiotidis, Simon van Norden and seminar participants at Nuffield College, the 2004 Centre for Growth and Business Cycle Research Conference in Manchester and the RES 2006 conference in Nottingham for very useful comments and suggestions.
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