Model Uncertainty and Financial Frictions: Implications for Optimal Monetary Policy
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Date
2024
Journal Title
Journal ISSN
Volume Title
Publisher
World Scientific Publ Co Pte Ltd
Abstract
The last decades proved that policymaking without considering uncertainty is impracticable. In an environment of uncertainty, policymakers have doubts about the policy models they routinely use. This paper focuses specifically on the situation where uncertainty on the financial side of the economy leads to misspecification in the policy model. We describe a coherent strategy for policymakers who are averse to model misspecification and analyze optimal policy design in the face of Knightian uncertainty. To do so, we augment a financial dynamic stochastic general equilibrium model with model misspecification in a simple minimax framework where the central bank plays a zero-sum game versus a hypothetical evil agent. The policy is tailored to insure against the worst-case outcomes. We show that model ambiguity on the financial side requires a passive monetary policy stance. However, if the uncertainty originates from the supply side of the economy, an aggressive response of interest rate is required. We also show the impact of an additional macroprudential tool on the dynamics of the economy.
Description
Özcan, Gülserim/0000-0002-8207-8930
Keywords
Model uncertainty, financial stability, optimal monetary policy, robust control, Knightian uncertainty
Turkish CoHE Thesis Center URL
Citation
0
WoS Q
Q3
Scopus Q
Source
Volume
69
Issue
2
Start Page
793
End Page
812