How Robustness Can Lower the Cost of Discretion

Model uncertainty has the potential to change importantly how monetary policy is conducted, making it an issue that central banks cannot ignore. Using a standard new Keynesian business cycle model, this paper analyzes the behavior of a central bank that conducts policy under discretion while fearing that its model is misspeci…ed. The main results are as follows. First, policy performance can be improved if the discretionary central bank implements a robust policy. This important result is obtained because the central bank’s desire for robustness directs it to assertively stabilize in‡ation, thereby mitigating the stabilization bias associated with discretionary policymaking. Second, the central bank’s fear of model misspeci…cation leads it to forecast future outcomes under the belief that in‡ation (in particular) will be persistent and have large unconditional variance, raising the probability of extreme outcomes. Private agents, however, anticipating the policy response, make decisions under the belief that in‡ation will be more closely stabilized, that is, more tightly distributed, than under rational expectations. Finally, as a technical contribution, the paper shows how to solve with robustness an important class of linear-quadratic decision problems. Keywords: Model uncertainty, robustness, uncertainty aversion, time-consistency. JEL Classi…cation: E52, E62, C61. Address for Correspondence: Economic Research, Mail Stop 1130, Federal Reserve Bank of San Francisco, 101 Market St, CA 94105, USA. Email: [email protected]. yI would like to thank the editor, two anonymous referees, Ulf Söderström, Peter Tillmann, and participants at the Royal Economic Society conference, 2008, and at the Computational Economics and Finance conference, 2008, for comments. I would also like to thank Anita Todd for editioral suggestions. The views expressed in this paper do not necessarily re‡ect those of the Federal Reserve Bank of San Francisco or the Federal Reserve System.