Uncertainty About the Persistence of Periods with Large Price Shocks and the Optimal Reaction of the Monetary Authority

24 Pages Posted: 1 Jun 2005  

Arnulfo Rodriguez

Independent Scholar

Jesus Gonzalez-Garcia

International Monetary Fund (IMF)

Fidel Gonzalez

Sam Houston State University - College of Business Administration - Department of Economics and International Business

Date Written: May 30, 2005

Abstract

Uncertainty about the persistence of periods characterized by large price shocks is an important aspect of monetary policy. This type of uncertainty posed some difficulties for central banks in 2004. This paper formalizes the treatment of this type of uncertainty by solving an optimal control problem in which the economy randomly alternates between two regimes characterized by different magnitudes of price shocks. By using an open economy model, we find that the optimal policy rule is both regime-contingent and robust. In particular, we find that: a) the optimal reaction of the interest rate is dependent on both the current regime and on the difference in the magnitude of the shocks between regimes; and b) after a robust selection of transition probabilities, the min-max probability of switching to the regime with large price shocks increases when such regime is more harmful. In general, cautious behavior renders smaller losses than recklessness for the monetary authority. This result argues in favor of caution over recklessness in the formulation of monetary policy when there is uncertainty about the persistence of periods with large price shocks.

Keywords: macroeconomic policy, model uncertainty, optimal control, robustness, Markov regime-switching, monetary policy, inflation targeting

JEL Classification: C61, E61

Suggested Citation

Rodriguez, Arnulfo and Gonzalez-Garcia, Jesus and Gonzalez, Fidel, Uncertainty About the Persistence of Periods with Large Price Shocks and the Optimal Reaction of the Monetary Authority (May 30, 2005). Available at SSRN: https://ssrn.com/abstract=732165 or http://dx.doi.org/10.2139/ssrn.732165

Arnulfo Rodriguez (Contact Author)

Independent Scholar ( email )

Mexico City, DF 06100
Mexico

Jesus Gonzalez-Garcia

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Room: HQ2 10A-572
Washington, DC 20431
United States
(202) 6236310 (Phone)
(202) 6236159 (Fax)

Fidel Gonzalez

Sam Houston State University - College of Business Administration - Department of Economics and International Business ( email )

Huntsville, TX 77341-2118
United States

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