Working Paper

On Monetary Policy, Model Uncertainty, and Credibility

Abstract: This paper studies the design of optimal time-consistent monetary policy in an economy where the planner and a representative household are faced with model uncertainty: While they are able to construct and agree on a reference model (probability distribution) governing the evolution of the exogenous state of the economy, a representative household has fragile beliefs and is averse to model uncertainty. In such environments, management of households' expectations becomes an active channel of optimal policymaking per se. A central banker who respects the fact that private sector models are imperfect and designs her optimal policy accordingly may be able not only to mitigate a fundamental time-inconsistency problem but also to sustain higher welfare. Interestingly, in some cases the resulting welfare is even higher than in models where both a central banker and a representative household are assumed to know the true model, i.e., to have rational expectations.

Keywords: robust control; monetary policy; time consistency; model uncertainty; management of expectations; credibility;

JEL Classification: C61; D81; E52; E61;

https://doi.org/10.17016/FEDS.2022.082

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2022-12

Number: 2022-082