Doubts About the Model and Optimal Policy

86 Pages Posted: 29 Aug 2020

See all articles by Anastasios G. Karantounias

Anastasios G. Karantounias

Federal Reserve Banks - Federal Reserve Bank of Atlanta

Multiple version iconThere are 2 versions of this paper

Date Written: July 23, 2020

Abstract

This paper analyzes optimal policy in setups where both the leader and the follower have doubts about the probability model of uncertainty. I illustrate the methodology in two environments: a) an industry populated with a large firm and many small firms in a competitive fringe, where both types of firms doubt the probability model of demand shocks, b) a general equilibrium economy, where a policymaker taxes linearly the labor income of a representative household in order to finance an exogenous stream of stochastic spending shocks. The policymaker can distrust the probability model of spending shocks more, the same, or less than the household.
Whenever there are doubts about the model, cautious agents form endogenous worst-case beliefs by assigning high probability on low-profitability or low-utility events. There are two forces that shape optimal policy results: the manipulation of the endogenous beliefs of the follower to the benefit of the leader, and the discrepancy (if any) in the pessimistic beliefs between the leader and the follower. Depending on the application, the leader may amplify or mitigate the worst-case beliefs of the follower.

Keywords: Model uncertainty, ambiguity aversion, multiplier preferences, misspecification, robustness, martingale, monopolist, competitive fringe, demand uncertainty, Ramsey taxation.

JEL Classification: D80, E62, H21, H63

Suggested Citation

Karantounias, Anastasios G., Doubts About the Model and Optimal Policy (July 23, 2020). Available at SSRN: https://ssrn.com/abstract=3659447 or http://dx.doi.org/10.2139/ssrn.3659447

Anastasios G. Karantounias (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Atlanta ( email )

1000 Peachtree Street N.E.
Atlanta, GA 30309-4470
United States

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