Robust Expectations and Uncertain Models - a Robust Control Approach with Application to the New Keynesian Economy

Bank of Finland Discussion Paper No. 5.2004

46 Pages Posted: 2 Jul 2004

Date Written: February 10, 2004

Abstract

This paper extends Svensson and Woodford's (2003) partial information framework by allowing the private agents to achieve robustness against incomplete information about the structure of the economy by distorting their expectations in a particular direction. It shows how a linear rational expectations equilibrium under concern for robustness can be solved by exploiting the recursive structure of the problem and appropriately modifying the Bellman equations in their framework. The standard Kalman filter is then used for information updating under imperfect measurement of the state variables. The standard New Keynesian model is used for illustrating how concern for modelling errors interacts with imperfect information. Agents achieve robustness by simultaneously over-estimating the persistence of exogenous shocks, but underestimating the policy response to the output gap. This under-estimation, combined with imperfect measurement, leads to larger and more persistent responses of private consumption to government expenditure shocks under robust expectations.

Keywords: expectations, robust control, model uncertainty, monetary policy,

JEL Classification: D81, C61, E52

Suggested Citation

Kilponen, Juha, Robust Expectations and Uncertain Models - a Robust Control Approach with Application to the New Keynesian Economy (February 10, 2004). Bank of Finland Discussion Paper No. 5.2004. Available at SSRN: https://ssrn.com/abstract=504962 or http://dx.doi.org/10.2139/ssrn.504962

Juha Kilponen (Contact Author)

Bank of Finland - Research ( email )

P.O. Box 160
FIN-00101 Helsinki
Finland
+358 10 831 2847 (Phone)
+358 10 831 2294 (Fax)

HOME PAGE: http://www.bof.fi/en/suomen_pankki/organisaatio/asiantuntijoita/kilponen_juha/

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