Real-time Optimal Monetary Policy With Undistinguishable Model Parameters And Shock Processes Uncertainty
Source: University of Sheffield
This paper studies optimal real time monetary policy when the central bank takes the volatility of the output gap and inflation as proxy of the undistinguishable uncertainty on the exogenous disturbances and the parameters of its model. The paper shows that when the uncertainty surrounding a specific state variable increases, the optimal policy response to that variable should increase too while the optimal response to the remaining state variables should attenuate or be unaffected. In this way the central bank moves preemptively to reduce the risk of large deviations of the economy from the steady state that would deteriorate the distribution forecasts. When an empirical test is carried out on the US economy the model predictions tend to be consistent with the data.