Robust Control and Persistence in the New Keynesian Economy

Since Keynes no economist would deny that expectations under uncertain conditions matter for the conduct of monetary policy, but still opinions about their formation are diverse. We build a hybrid New Keynesian Framework to analyze the in‡uence of model uncertainty on optimal interest rates under di¤erent degrees of rational forward-looking behavior, using recently developed robust control techniques. Impulse response functions illustrate that uncertainty seems to be a rationale for more aggressive interest rate reactions, but also suggest that the degree of forward-looking behavior seems to be more important than an appropriate fear about the misspeci…cation of a given model. Furthermore, we argue that assuming to control in‡ation through expectations is a policy on the razor’s edge, since robust expectations overestimate shock impacts. This questions the gains from commitment under uncertainty. Keywords: Robust Control, Knightian Uncertainty, Monetary Policy, Forward-Looking Expectations, Model Uncertainty. JEL classi…cation: C61; C68; D81; E5; E52; E58; E61 email: [email protected]