How Robustness Can Lower the Cost of Discretion
Journal of Monetary Economics 57(6), September 2010, 653-667
+ abstract Model uncertainty has the potential to change importantly how monetary policy is conducted, making it an issue that central banks cannot ignore. Using a standard new Keynesian business cycle model, this paper analyzes the behavior of a central bank that conducts policy under discretion while fearing that its model is misspecified. The main results are as follows. First, policy performance can be improved if the discretionary central bank implements a robust policy. This important result is obtained because the central bank's desire for robustness directs it to assertively stabilize inflation, thereby mitigating the stabilization bias associated with discretionary policymaking. Second, the central bank's fear of model misspecification leads it to forecast future outcomes under the belief that inflation (in particular) will be persistent and have large unconditional variance, raising the probability of extreme outcomes. Private agents, however, anticipating the policy response, make decisions under the belief that inflation will be more closely stabilized, that is, more tightly distributed, than under rational expectations. Finally, as a technical contribution, the paper shows how to solve with robustness an important class of linear-quadratic decision problems.
When Is Discretion Superior to Timeless Perspective Policymaking?
Journal of Monetary Economics 57(3), April 2010, 266-277
+ abstract The monetary policy literature assumes increasingly that policies are formulated according to the timeless perspective (Woodford 1999a). However, treating the auxiliary state variables that characterize the timeless perspective equilibrium appropriately when evaluating policy performance, this paper shows that discretionary policymaking can be superior to timeless perspective policymaking and identifies model features that make this outcome more likely. Using standard New Keynesian DSGE models, discretion is found to dominate timeless perspective policymaking when the price/wage Phillips curves are relatively flat, due, perhaps, to firm-specific capital (or labor) and/or Kimball (1995) aggregation in combination with nominal rigidities. These results suggest that studies applying the timeless perspective might also usefully compare its performance to discretion, paying careful attention to how policy performance is evaluated.
Methods for Robust Control
Journal of Economic Dynamics and Control 33(8), August 2009, 1604-1616 :: With Leitemo and Soderstrom
+ abstract Robust control allows policymakers to formulate policies that guard against model misspecification. The principal tools used to solve robust control problems are state-space methods (see Hansen and Sargent 2008, and Giordani and Soderlind 2004). In this paper we show that the structural-form methods developed by Dennis (2007) to solve control problems with rational expectations can also be applied to robust control problems, with the advantage that they bypass the task, often onerous, of having to express the reference model in state-space form. In addition, we show how to implement two different timing assumptions with distinct implications for the robust policy and the economy. We apply our methods to a New Keynesian dynamic stochastic general equilibrium model and find that robustness has important effects on policy and the economy.
Consumption-Habits in a New Keynesian Business Cycle Model
Journal of Money, Credit, and Banking 41(5), August 2009, 1015-1030
+ abstract Consumption-habits have become an integral component in new Keynesian models. However, consumption-habits can be modeled in a host of different ways and this diversity is reflected in the literature. I examine whether different approaches to modeling consumption habits have important implications for business cycle behavior. Using a standard new Keynesian business cycle model, I show that, to a first-order log-approximation, the consumption Euler equation associated with the additive functional form for habit formation encompasses the multiplicative function form. Empirically, I show that whether consumption habits are internal or external has little effect on the model's business cycle characteristics.
Robust Control with Commitment: A Modification to Hansen-Sargent
Journal of Economic Dynamics and Control 32(7), July 2008, 2061-2084
+ abstract I examine the Hansen and Sargent [2003. Robust control of forward-looking models. Journal of Monetary Economics 50, 581-604] formulation of the robust Stackelberg problem and show that their method of constructing the approximating equilibrium is generally invalid. I then turn to the Hansen and Sargent [2007. Robustness, manuscript (version dated March 22, 2007)] treatment, which, responding to the problems raised in this paper, changes subtly, but importantly, how the robust Stackelberg problem is formulated. In the context of Hansen and Sargent [2007. Robustness, manuscript (version dated March 22, 2007)], I prove, first, that their method for obtaining the approximating equilibrium is now equivalent to the one developed in this paper, and, second, that the worst-case specification errors are not subject to a time-consistency problem. In the context of the Erceg et al. [2000. Optimal monetary policy with staggered wage and price contracts. Journal of Monetary Economics 46, 281-313] sticky wage/sticky price model, I find that a robust central bank will fear primarily that the supply side of its approximating model is misspecified and that robustness affects importantly central bank promises about future policy.
Learning and Optimal Monetary Policy
Journal of Economic Dynamics and Control 32(6), June 2008, 1964-1994 :: With Ravenna
+ abstract To conduct policy efficiently, central banks must use available data to infer, or learn, the relevant structural relationships in the economy. However, because a central bank's policy affects economic outcomes, the chosen policy may help or hinder its efforts to learn. This paper examines whether real-time learning allows a central bank to learn the economy's underlying structure and studies the impact that learning has on the performance of optimal policies under a variety of learning environments. Our main results are as follows. First, when monetary policy is formulated as an optimal discretionary targeting rule, we find that the rational expectations equilibrium and the optimal policy are real-time learnable. This result is robust to a range of assumptions concerning private-sector learning behavior. Second, when policy is set with discretion, learning can lead to outcomes that are better than if the model parameters are known. Finally, if the private sector is learning, then unannounced changes to the policy regime, particularly changes to the inflation target, can raise policy loss considerably.
Optimal Policy in Rational Expectations Models: New Solution Algorithms
Macroeconomic Dynamics 11(1), February 2007, 31-55
+ abstract This paper develops methods to solve for optimal discretionary policies and optimal commitment policies in rational expectations models. These algorithms, which allow the optimization constraints to be conveniently expressed in second-order structural form, are more general than existing methods and are simple to apply. We use several New Keynesian business cycle models to illustrate their application. Simulations show that the procedures developed in this paper can quickly solve small-scale models and that they can be usefully and effectively applied to medium- and large-scale models.
How Important Is Precommitment for Monetary Policy?
Journal of Money, Credit, and Banking 38(4), June 2006, 847-872 :: With Soderstrom
+ abstract We quantify the welfare differential between precommitment and discretionary monetary policy in three estimated models of the U.S. economy by calculating the permanent deviation of inflation from target that in welfare terms is equivalent to moving from discretion to precommitment. Using a range of reasonable central bank preference parameters, this "inflation equivalent" ranges from 0.05 to 3.6 percentage points, with a midpoint of either 0.15 or 1-1.5 percentage points, depending on the model. In addition to the degree of forward-looking behavior, we show that the existence of transmission lags and/or information lags is crucial for determining the welfare gain from precommitment.
The Policy Preferences of the U.S. Federal Reserve
Journal of Applied Econometrics 21(1), January 2006, 55-77
+ abstract In this paper I model and explain U.S. macroeconomic outcomes subject to
the discipline that monetary policy is set optimally. Exploiting the restrictions that come from optimal policymaking, I estimate the parameters in the Federal Reserve's policy objective function together with the parameters in its optimization constraints. For the period following Volcker's appointment as chairman, I estimate the implicit inflation target to be around 1.4 percent and show that policymakers assigned a significant weight to interest rate smoothing. I show that the estimated optimal policy provides a good description of U.S. data for the 1980s and 1990s.
Inferring Policy Objectives from Economic Outcomes
Oxford Bulletin of Economics and Statistics 66(s1), September 2004, 735-764
+ abstract Estimated policy rules are reduced-form equations that are silent on many important policy questions. However, a structural understanding of monetary policy can be obtained by estimating a policymaker's objective function. The paper derives conditions under which the parameters in a
policymaker's policy objective function can be identified and estimated. I apply these conditions to a New Keynesian sticky-price model of the U.S. economy. The results show that the implicit inflation target and the relative weight placed on interest rate smoothing both declined when Paul Volcker was appointed Federal Reserve chairman.
Solving for Optimal Simple Rules in Rational Expectations Models
Journal of Economic Dynamics and Control 28(8), June 2004, 1635-1660
+ abstract This paper presents algorithms that solve for optimal simple monetary
policy rules in rational expectations models with precommitment and discretion. The algorithms are applied to the models in Fuhrer (1997), Clarida et al. (1999), and Rudebusch (2002) to examine the efficiency properties of operational policy rules. We show that optimized Taylor-type rules perform well in these models, but that, aside from the Fuhrer-Moore model, this result is sensitive to whether the central bank can respond to current period shocks. Taylor-type rules that are operational in the sense that they do not respond to current period information are found to be highly inefficient in the Rudebusch model and in the Clarida et al. model.
Exploring the Role of the Real Exchange Rate in Australian Monetary Policy
Economic Record 79(244), March 2003, 20-38
+ abstract An important issue in small open economies is whether policymakers
should respond to exchange rate movements when they formulate monetary
policy. Microfounded models tend to suggest that there is little to be
gained from responding to exchange rate movements, and the literature has largely concluded that such a response is unnecessary, or even undesirable. This paper examines this issue using an estimated model of the Australian economy. In contrast to microfounded models, according to this model policymakers should allow for movements in the real exchange rate and the terms-of-trade when they set interest rates. Further, taking real exchange rate movements into account appears even more important with price level targeting than with inflation targeting.
Inflation Expectations and the Stability Properties of Nominal GDP Targeting
The Economic Journal 111(468), January 2001, 103-113
+ abstract Ball (1999) uses a small closed economy model to show that nominal GDP
targeting can lead to instability. This paper extends Ball's model to uncover the role inflation expectations play in generating this instability. Allowing inflation expectations to be formed by the more general mixed expectations process, which encompasses Ball's model, we show that nominal GDP targeting is unlikely to lead to instability. We further show that in Ball's model where exact targeting causes instability, moving to inexact targeting restores stability.
Discretionary Monetary Policy with Costly Inflation
Economics Letters 65(1), January 1999, 91-96
