Infrequent Changes of Policy Target: Stop-Go Monetary Policy under Ambiguity

In many countries, the monetary policy instrument remains unchanged for a long period and shows infrequent responses to exogenous shocks. The purpose of this paper is to provide a new explanation on why the central bank’s policy instrument remains so unchanged. In the following analysis, we explore how Knightian uncertainty affects optimal monetary policy. We apply the Choquet expected decision theory to a new Keynesian model. A main result is that the policymaker may frequently keep the interest rate unchanged even when exogenous shocks change output gaps and inflation rates. This never happens when the policymaker has no uncertainty aversion. But to the extent that a change of the interest rate increases uncertainty, the policymaker, who has some uncertainty aversion, may maintain an unchanged policy stance for some significant periods and make discontinuous changes of the target rate following a Taylor rule. Our analysis departs from previous studies in that the policymaker can observe noisy information of relevant macro variables before making the policy decision. The optimal monetary policy rule allows time-variant feedback parameters. This leads to an optimal stop-go policy rule that sometimes responds to output and inflation gaps but sometimes does not. JEL Classification Numbers: E40, E52, D81