Risk Management in Action - Robust Monetary Policy Rules under Structured Uncertainty

62 Pages Posted: 4 Mar 2008

See all articles by Paul Levine

Paul Levine

School of Economics, University of Surrey

Peter McAdam

European Central Bank (ECB); University of Surrey, Economics

Joseph Pearlman

London Metropolitan University - Department of Economics, Finance and International Business (EFIB)

Richard G. Pierse

University of Surrey - Department of Economics; National Institute of Economic and Social Research (NIESR)

Date Written: February 2008

Abstract

Recent interest in 'Risk Management' has highlighted the relevance of Bayesian analysis for robust monetary-policy making. This paper sets out a comprehensive methodology for designing policy rules inspired by such considerations. We design rules that are robust with respect to model uncertainty facing both the policymaker and private sector. We apply our methodology to three simple interest-rate rules: inflation-forecast-based (IFB) rules with a discrete forward horizon, one targeting a discounted sum of forward inflation, and a current wage inflation rule. We use an estimated DSGE model of the euro area and estimated measures of structured exogenous and parameter uncertainty for the exercise. We find that IFB rules with a long horizon perform poorly with or without robust design. Our discounted future targeting rule performs much better, indicating that policy can be highly forward-looking without compromising stabilization. The wage inflation rule dominates whether it is designed to have good robust properties or not.

Keywords: Interest-rate rules, robustness, structured uncertainty

JEL Classification: E52, E37, E58

Suggested Citation

Levine, Paul L. and McAdam, Peter and Pearlman, Joseph G. and Pierse, Richard G., Risk Management in Action - Robust Monetary Policy Rules under Structured Uncertainty (February 2008). ECB Working Paper No. 870. Available at SSRN: https://ssrn.com/abstract=1090545

Paul L. Levine (Contact Author)

School of Economics, University of Surrey ( email )

Guildford
Surrey GU2 7XH
United Kingdom
+44 1483 259 380 Ext. 2773 (Phone)
+44 1483 259 548 (Fax)

Peter McAdam

European Central Bank (ECB) ( email )

Kaiserstrasse 29
Eurotower
D-60311 Frankfurt am Main
Germany
0049 69 13440 (Phone)
0044 69 1344 6000 (Fax)

University of Surrey, Economics ( email )

Guildford
Guildford, Surrey GU2 5XH
United Kingdom

Joseph G. Pearlman

London Metropolitan University - Department of Economics, Finance and International Business (EFIB) ( email )

Economics Subject Group, LMBS
London EC2M 6SQ, EC2M 6SQ
United Kingdom

Richard G. Pierse

University of Surrey - Department of Economics ( email )

Guildford
Surrey GU2 7XH
United Kingdom

National Institute of Economic and Social Research (NIESR) ( email )

2 Dean Trench Street
Smith Square
London SW1P 3HE
United Kingdom

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