The amplification of the New Keynesian models and robust optimal monetary policy

Abstract

This paper analyzes whether and how model uncertainty affects the amplification mechanism of the New Keynesian models in a simple min-max framework where the central bank plays a zero-sum game versus a hypothetical, evil agent. A first finding on a benchmark model with staggered price setting is that a robust optimal commitment policy necessitates more aggressive policy under a demand shock. Further, bringing additional persistence into the model deteriorates the effectiveness of monetary policy. Hence, allowing for either habit formation or partial indexation of prices to lagged inflation rate requires a stronger response for the policy to a demand shock. Together with the specification doubts, in order to reassure the private sector and signal that it will stabilize the fluctuations in the output gap, the policymaker reacts more aggressively as persistence rises. Although inflation persistence does not change the impact of model uncertainty, habit formation in consumption eliminates even reverses the impact of uncertainty on the policy reaction to a supply shock. In all cases, policymaker attributes less importance to nominal interest rate inertia with concerns about model uncertainty.