Kai Leitemo

Robust Monetary Policy in a Small Open Economy

This paper studies how a central bank’s preference for robustness against model misspecification affects the design of monetary policy in a New-Keynesian model of a small open economy. Due to the simple model structure, we are able to solve analytically for the optimal robust policy rule, and we separately analyze the effects of robustness against misspecification concerning the determination of inflation, output and the exchange rate. We show that an increased central bank preference for robustness makes monetary policy respond more aggressively or more cautiously to shocks, depending on the type of shock and the source of misspecification.

Robust Monetary Policy in the New-Keynesian Framework

We study the effects of model uncertainty in a simple New-Keynesian model using robust control techniques. Due to the simple model structure, we are able to find closed-form solutions for the robust control problem, analyzing both instrument rules and targeting rules under different timing assumptions. In all cases but one, an increased preference for robustness makes monetary policy respond more aggressively to cost shocks but leaves the response to demand shocks unchanged. As a consequence, inflation is less volatile and output is more volatile than under the non-robust policy. Under one particular timing assumption, however, increasing the preference for robustness has no effect on the optimal targeting rule (nor on the economy).

Discretion and the Transmission Lags of Monetary Policy

Monetary policy transmission lags create credibility problems for the inflationtargeting policy maker who acts under discretion. We show that if prices react to monetary policy with a longer lag than output, the welfare maximizing inflationtargeting policy implies no policy stabilization of cost-push shocks in the canonical New Keynesian model. The reason is simple: for the period monetary policy influences output, inflation is predetermined and the best discretionary policy is to stabilize the output gap fully. We find that money growth targeting comes close to replicating the welfare-maximizing policy under commitment if there are transmission lags. Keywords: discretionary and stabilization bias, monetary policy, transmission lags, inflation targeting, money targeting JEL classification numbers: E52, E58, E61

Simple Monetary Policymaking without the Output Gap

Several research contributions have argued that information about the output gap is essential for a good monetary policy rule. However, as pointed out by Orphanides (2001), there is considerable real-time uncertainty about the size of the output gap. The paper argues that simple monetary policy rules that rely exclusively on (survey-based) information about future and past inflation rates may be more efficient than optimized Taylor rules once realtime output gap uncertainty is accounted for. Even when only information about historical inflation rates is available, a very simple policy rule may be constructed that improves on the Taylor rule.

Monetary Policy in a Small Open Economy With a Preference for Robustness

We use robust control techniques to study the effects of model uncertainty on monetary policy in an estimated, semi-structural, small-open-economy model of the U.K. Compared to the closed economy, the presence of an exchange rate channel for monetary policy not only produces new trade-offs for monetary policy, but it also introduces an additional source of specification errors. We find that exchange rate shocks are an important contributor to volatility in the model, and that the exchange rate equation is particularly vulnerable to model misspecification, along with the equation for domestic inflation. However, when policy is set with discretion, the cost of insuring against model misspecification appears reasonably small.

Robustness in Monetary Policymaking: A Case for the Friedman Rule

Inflation targeting involves using all available information in stabilizing inflation around some target rate (Svensson, 2003). Inflation is typically at the very end of the transmission mechanism and hence its determination is subject to much model uncertainty which the central bank will want to guard against using robust policies. Such robustness comes however with the cost of increased social loss under the most likely description of the economy. We show that with a sufficiently high degree of model uncertainty, adherence to the Friedman rule of increasing the money stock by k percent will be superior as the price paid for robustness is smaller. Key words: policy robustness, money growth targeting, inflation targeting, Friedman rule JEL classification numbers: E42, E52, E58, E61