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.
Dennis, Richard. 2007. “How Robustness Can Lower the Cost of Discretion,” Federal Reserve Bank of San Francisco Working Paper 2007-09. Available at https://doi.org/10.24148/wp2007-09