Simple Versus Optimal Rules as Guides to Policy

FRB of Atlanta Working Paper 2007-7

44 Pages Posted: 13 May 2007

See all articles by William A. Brock

William A. Brock

University of Wisconsin, Madison - Department of Economics; University of Missouri at Columbia - Department of Economics

Steven N. Durlauf

University of Chicago; National Bureau of Economic Research (NBER)

James M. Nason

North Carolina State University - Department of Economics

Giacomo Rondina

University of Wisconsin - Madison

Date Written: April 2007

Abstract

This paper contributes to the policy evaluation literature by developing new strategies to study alternative policy rules. We compare optimal rules to simple rules within canonical monetary policy models. In our context, an optimal rule represents the solution to an intertemporal optimization problem in which a loss function for the policymaker and an explicit model of the macroeconomy are specified. We define a simple rule to be a summary of the intuition policymakers and economists have about how a central bank should react to aggregate disturbances. The policy rules are evaluated under minimax and minimax regret criteria. These criteria force the policymaker to guard against a worst-case scenario, but in different ways. Minimax makes the worst possible model the benchmark for the policymaker, while minimax regret confronts the policymaker with uncertainty about the true model. Our results indicate that the case for a model-specific optimal rule can break down when uncertainty exists about which of several models is true. Further, we show that the assumption that the policymaker's loss function is known can obscure policy trade-offs that exist in the short, medium, and long run. Thus, policy evaluation is more difficult once it is recognized that model and preference uncertainty can interact.

Keywords: monetary policy rule, model uncertainty, minimax, minimax regret

JEL Classification: E3, E5, E6

Suggested Citation

Brock, William A. and Durlauf, Steven N. and Nason, James M. and Rondina, Giacomo, Simple Versus Optimal Rules as Guides to Policy (April 2007). FRB of Atlanta Working Paper 2007-7. Available at SSRN: https://ssrn.com/abstract=985168 or http://dx.doi.org/10.2139/ssrn.985168

William A. Brock

University of Wisconsin, Madison - Department of Economics ( email )

1180 Observatory Drive
Madison, WI 53706
United States
608-263-6655 (Phone)
608-263-3876 (Fax)

University of Missouri at Columbia - Department of Economics ( email )

118 Professional Building
Columbia, MO 65211
United States

Steven N. Durlauf

University of Chicago ( email )

1155 East 60th Street
Chicago, IL 60637
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

James M. Nason (Contact Author)

North Carolina State University - Department of Economics ( email )

Campus Box 8110
NC State University
Raleigh, NC 27695-8110
United States
(919) 513-2884 (Phone)
(919) 515-5613 (Fax)

Giacomo Rondina

University of Wisconsin - Madison ( email )

716 Langdon Street
Madison, WI 53706-1481
United States

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