DEALING WITH UNCERTAINTY: ROBUST RULES IN MONETARY POLICY
| Date | 01 May 2007 |
| DOI | http://doi.org/10.1111/j.1467-9485.2007.00416.x |
| Author | Maria Demertzis,Alexander F. Tieman |
| Published date | 01 May 2007 |
DEALING WITH UNCERTAINTY:
ROBUST RULES IN MONETARY POLICY
Maria Demertzis
n
and Alexander F. Tieman
nn
Abstract
We argue that in seeking to insure against model uncertainty, monetary policy
makers are often ready to trade ex post performance for greater certainty in the
outcome. They thus look for rules that although not optimal ex post, have certain
properties that qualify them as robust. We apply first, Gul’s approach of
‘disappointment’ aversion to describe policy makers’ aversion to uncertainty and
then define the properties the notion of ‘robustness’ entails. With these two tools we
then link the desirability of such robust rules to the degree of policy makers’
aversion to uncertainty. We thus show that provided such robust rules exist, a
larger degree of disappointment aversion leads to a greater emphasis on robustness
in policy implementation.
I Intro ductio n
Referring to the FOMC reaction of lowering the federal rate from 1.75% to
1.25% following the Russian debt default in the autumn of 1998, chairman
Greenspan (2004) addressed the issue of uncertainty by saying,
The produce of a low-probability event and a potentially severe outcome was
judged a more serious threat to economic performance than the higher
inflation that might ensue in the more probable scenario.
This statement encapsulates two very important facts about the running of
monetary policy. First, authorities take policy decisions under substantial levels
of uncertainty. Second, far from being indifferent to the degree of uncertainty
prevailing, monetary policy makers are considerably more displeased with the
possibility of ‘bad’ outcomes than is justified by their probability of occurring.
In this paper, we deal with a specific type of uncertainty, namely model
uncertainty, and argue that as a consequence of the above, any attempt to
examine how monetary policy authorities apply ‘risk-management’ (Greenspan,
2004) needs to allow for this asymmetry in the way Central Banks (CBs)
approach it. To this end, we apply the framework of disappointment averse
n
De Nederlandsche Bank and University of Amsterdam
nn
International Monetary Fund
Scottish Journal of Political Economy, Vol. 54, No. 2, May 2007
r2007 The Authors
Journal compilation r2007 Scottish Economic Society. Published by Blackwell Publishing Ltd,
9600 Garsington Road, Oxford, OX4 2DQ, UK and 350 Main St, Malden, MA, 02148, USA
295
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