A Positive Theory of Monetary Policy and Robust Control
Bank of Finland Discussion Paper No. 18/2003
29 Pages Posted: 29 Oct 2003
Date Written: August 12, 2003
This paper applies the robust control approach to a simple positive theory of monetary policy, when the central bank's model of the economy is subject to misspecifications. It is shown that a central bank should react more aggressively to supply shocks when the model misspecifications grow larger. Moreover, the model misspecifications aggravate the inflation bias and a trade-off between output stabilisation and inflation worsens when the uncertainty surrounding the central bank's model increases. This implies that the larger the model misspecifications are, the more inflation-averse the central bank should be.
Keywords: Risk-sensitivity, robust control theory, monetary policy, Brainard conservatism, model uncertainty
JEL Classification: E58
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