On Robust Monetary Policy with Structural Uncertainty

Similar documents
On Macroeconomic Theories and Modeist

2014 Summer Course School of Business, Nanjing University. State-Space Modelling and Its Applications in Economics and Finance

Discussion of Jeremy J. Nalewaik: The Income and Product Side Estimates of U.S. Output Growth

MONEY, CREDIT, AND FEDERAL RESERVE POLICY: REPLY TO PORTER AND OFFENBACHER

AARHUS UNIVERSITY. PhD course. Fractional Time Series Models. Aarhus University. Department of Economics and Business

Consumer Confidence Surveys: Can They Help Us Forecast Consumer Spending in Real Time?

Liang Wang University of Hawaii Manoa. Randall Wright University of Wisconsin Madison Federal Reserve Bank of Minneapolis

Comment on A Macroeconomic Framework for Quantifying Systemic Risk by He and Krishnamurthy

Lecture 1 - Introduction

Economics. Synopsis. 1. Economic Concepts, Issues and Tools. 2. An Overview of Economics. Sections. Learning Summary. Sections

DISCUSSION OF ELLISON AND SARGENT: WHAT QUESTIONS ARE STAFF AND FOMC FORECASTS SUPPOSED TO ANSWER?

Artificial Intelligence Qual Exam

Time Series Methods in Financial Econometrics Econ 509 B1 - Winter 2017

INTERNATIONAL MONETARY FUND. Joint Vienna Institute / IMF Institute. Course on Macroeconomic Forecasting (JV10.14) Vienna, Austria

Chapter 3. Introduction to Quantitative Macroeconomics. Measuring Business Cycles. Yann Algan Master EPP M1, 2010

Chapter 5 Review Questions

Stylized Facts of Business Cycles in the OECD Countries

THE CYCLICAL BEHAVIOR OF PRICES: EVIDENCE FROM SEVEN DEVELOPING COUNTRIES

Determinants of Money Demand Function in Ethiopia. Amerti Merga. Adama Science and Technology University

Evaluating the Configuration of the Federal. Reserve System in the Twenty-First Century. Swati Joshi

Department of Economics, University of Michigan, Ann Arbor, MI

Opening Remarks. Alan Greenspan

Individual Charts Done Right and Wrong

Empirical Tests of Exchange Rate Theory

Curriculum Vitae. Andrew G. Atkeson

MARK SCHEME for the May/June 2010 question paper for the guidance of teachers 9772 ECONOMICS. 9772/02 Paper 2 (Essays), maximum raw mark 75

Advanced Macroeconomic Techniques

Spring Macroeconomics, sixth edition, Andrew B. Abel and Ben S. Bernanke, Pearson/Addison- Wesley 2005.

Professor: Franck Portier (with occasional lectures by Paul Beaudry)

Career Development: A Two-Way Street

Testing the Predictability of Consumption Growth: Evidence from China

The Rational Expectations Hypothesis

The Economist as a Scientist

Relationship Between Energy Prices, Monetary Policy and Inflation; A Case Study of South Asian Economies

Relationship Between Energy Prices, Monetary Policy and Inflation; A Case Study of South Asian Economies

Imperfect Knowledge Expectations, Uncertainty Adjusted UIP and Exchange Rate Dynamics: A Comment

The Cost of Punishment: Fairness in High-Stakes Ultimatum Games

Economic Analysis for Business and Strategic Decisions. The Fundamentals of Managerial Economics

Osaka University of Economics Working Paper Series. No Reexamination of Dornbusch s Overshooting Model: Empirical Evidence on the Saddle Path

Shewhart, Deming, and Six Sigma

Empirical Evidence on the Demand for Money

Watson-Glaser III Critical Thinking Appraisal (US)

Seminar Master Major Financial Economics : Quantitative Methods in Finance

The GPEDC theory of change : An exposition and critique

Performance criteria

Project Management. 1. Introduction

THE RESPONSE OF FINANCIAL AND GOODS MARKETS TO VELOCITY INNOVATIONS: AN EMPIRICAL INVESTIGATION FOR THE US*

Multiple Equilibria and Selection by Learning in an Applied Setting

How Do Environmental and Natural Resource Economics Texts Deal With the Simple Model of the Intertemporal Allocation of a Nonrenewable Resource?

General Discussion: Separating the Business Cycle from Other Economic Fluctuations

Econ 210C: Macroeconomic Theory

The Role of Education for the Economic Growth of Bulgaria

Thirty Five Years of Model Building for Monetary Policy Evaluation: Breakthroughs, Dark Ages, and a Renaissance. John B. Taylor 1.

BRIEFING NOTES Five Theories on Contemporary Board Governance

The nine keys to achieving growth through innovation By Dr Amantha Imber

by Harald Uhlig Humboldt University Berlin, CentER, Bundesbank and CEPR

Rt Hon Nicky Morgan MP Chair of the Treasury Committee House of Commons Committee Office London SW1A 0AA. Sent by .

Watson Glaser III (US)

The Critical Role of Talent Analytics in Successful Mergers and Acquisitions

Prospect theory and investment decision behavior: A review

Roundtable Discussion Academic Help Wanted: A Policymaker s Perspective. Athanasios Orphanides Board of Governors of the Federal Reserve System

Research on Theoretical Analysis of Unemployment Rates Interim Report. Summary

Shewhart and the Probability Approach. The difference is much greater than how we compute the limits

Performance Management Behaviors that Matter

FACTOR-AUGMENTED VAR MODEL FOR IMPULSE RESPONSE ANALYSIS

Introduction [to Recent Developments in the Theory of Involuntary Unemployment]

Harry Ridgewell: So do you think that the Atlas is being a bit misleading when it says 75% of the world's land is degraded?

S E L E C T D E V E L O P L E A D H O G A N L E A D V A L U E S CORE VALUES AND MOTIVATORS FOR LEADERSHIP ROLES. Report for: John Doe ID: HA154779

Date Advances Declines Net Advance AD Line

2 Grossman-Hart (1986) as a Theory of Markets

VEYS OF CONSUME IVE Surveys of Consumers I TY OF MIC

Mind Your Own Business

8. Consumption, uncertainty, and the current account

The Australian Business Cycle: A New View by Don Harding The Melbourne Institute. Comments by David Gruen * Reserve Bank of Australia

Strategic Oil Dependence TranSust.Scan Madrid Workshop, 2-4 April 2008

Certainty vs hesitation. Sharpen the findings of traditional surveys.

ECON 269A. Winter Time and Location: Tu-Th PM Course Webpage:

Thirty-Five Years of Model Building for Monetary Policy Evaluation: Breakthroughs, Dark Ages, and a Renaissance

BATTLE ROYAL: ZERO-PRICE EFFECT vs RELATIVE vs REFERENT THINKING. Juan L. Nicolau

Credit, Money and Banking: Syllabus

Monetary Theory And Policy Walsh Solution Manual

How to create scenarios for change

CHAPTER 2. Conceptual Framework for Financial Reporting 9, 10, 11, 30 6, Basic assumptions. 12, 13, 14 5, 7, 10 6, 7

Optimal Currency Areas

The Allais Paradox, discovered by Maurice Allais, provides an example in decision theory of

Chapter 19. Confidence Intervals for Proportions. Copyright 2012, 2008, 2005 Pearson Education, Inc.

Macro I reading list Fall 2006

Economics Lecture notes- Semester 1:

Workshop on Central Bank Models, Session II Central Banker s Modeling Toolbox: One-for-All or All-for-One?

as explained in [2, p. 4], households are indexed by an index parameter ι ranging over an interval [0, l], implying there are uncountably many

The Dirty Little Secret of Software Pricing

OF THE FIRM A NOTE ON THE THEORY OF INVESTMENT

Advanced Macroeconomic Theory I: Syllabus

A Store of Value Starts With Stability

Modelling Financial Markets

Dominion Virginia Power and Clean Power Plan Costs: A brief review of the Dominion s 2015 Integrated Resource Plan compliance cost estimates

Over the past decade or so,

Economic Forecasting in the Private and Public Sectors. Remarks by- Alan Greenspan. Chairman of the Board of Governors of the Federal Reserve System

Macroeconomic Modeling and Forecasting

What is economics? Economics is the study of how people use the limited economic resources to fulfill their unlimited needs of goods and services

Transcription:

Diebold, F.X. (2005), "On Robust Monetary Policy with Structural Uncertainty," in J. Faust, A. Orphanedes and D. Reifschneider (eds.), Models and Monetary Policy: Research in the Tradition of Dale Henderson, Richard Porter, and Peter Tinsley. Washington, DC: Board of Governors of the Federal Reserve System, 82-86. On Robust Monetary Policy with Structural Uncertainty Discussion of John C. Williams Robust Estimation and Monetary Policy with Unobserved Structural Change Francis X. Diebold University of Pennsylvania and NBER July 2004 It is a pleasure to help honor my friends and former colleagues Dale Henderson, Dick Porter, and Peter Tinsley, by discussing Williams fine paper and the important ongoing research program to which it contributes, all of which is very much in the Henderson-Porter-Tinsley tradition of path-breaking application of optimal control methods to the conduct of monetary policy. 1. Beauty and the Beast The recent robust control literature in general, and Williams paper in particular, hits a very sweet spot. First, it has an beautiful theoretical purity, very much the latest step in the rigorous and stunningly influential prediction and control program of Weiner, Kolmogorov, Kalman, Whittle, Sargent, and Hansen. The essence of robust control is acknowledgment and incorporation of model uncertainty in optimal control. 1 Effectively, the robust control framework is a flexible and powerful laboratory for exploring local perturbations to rational expectations. 2 1 For a masterful survey, see Hansen and Sargent (2004). 2 I borrowed this insight from Tom Sargent.

Second, Williams robust control perspective has a complementary and equally-appealing applied relevance. Surely, in practice, we do not know the true macroeconomic model with respect to which we seek to perform control. Hence control methods robust to lack of knowledge of the true model should contribute significantly to improved policy deliberations. Against this optimistic background, however, a tension arises: the theoretical robust control framework as presently developed may not be fully up to the applied challenge. That is, realistic monetary policy environments may involve deviations from model certainty best characterized as global, rather than local, so that naive implementations and interpretations of robust control may promote an inappropriate complacency a feeling that the robustness problem has been fully solved, and that monetary policy is now robust to model uncertainty. 2. How Robust is Robust Control? Over the years, we have made progress in acknowledging various forms of uncertainty in control environments: (1) Initially, we acknowledged only parameter uncertainty; that is, we assumed the true model known but acknowledged that its parameters were estimated. (2) Next, we acknowledged both model and parameter uncertainty; we assumed the true model unknown but a member of a well-defined set, and we acknowledged that the fitted model s parameters were estimated. (3) Most recently in the present paper Williams treats model uncertainty, parameter uncertainty, and structure uncertainty. He assumes the true model unknown but a member of a well-defined set, acknowledges that the fitted model s parameters are estimated, and acknowledges that the fitted model s parameter(s) may possibly change over time.

The progress claimed above really is progress, but unfortunately it may be more limited than it appears at first glance. In particular, in every case, we heroically assume that the set of possible models is known. That is, we assume that the models under consideration constitute the universe of relevant models. In (1) we assume a single fixed-parameter model, in (2) we assume a set of possible fixed-parameter models, and in (3) we assume a set of possible fixed-parameter models augmented with structural change models. The assumption of a known model set ensures that posterior probabilities sum to unity and hence delivers powerful results. For example, combined forecasts may be constructed trivially as posterior weighted averages across the individual model forecasts. Moreover, and of more direct relevance to the present paper, the assumption facilitates robust (minimax) control by rendering the minimax calculation well-posed. However, a serious issue arises. If the assumed model set is too small, with potentially relevant models omitted, then the corresponding minimax robust control will be incompletely robustified. 3 Consider Williams paper, in which he represents structural change by variation in the natural rate of unemployment. Surely one could take issue with that representation, as structural change may be operative in many other ways. The key point, however, is that even within that representation, the assumed set of potential natural rate models (stationary ARMA, ARFIMA, and Markov-switching) is very limited. Indeed, as shown by Diebold and Rudebusch (1991) and Diebold and Inoue (1998), in many typical cases the seemingly-different ARMA, ARFIMA, and Markov-switching models may be almost indistinguishable, which suggests that Williams robust control may indeed be under-robustified relative to an appropriate model set with more diversity. 3 The situation roughly parallels the specification of the model set in White s (2000) Reality Check for data-snooping bias.

3. On the Evolution of Central Bankers Implicit and Explicit Contracts Williams paper is normative, or prescriptive. It tells what should be done to obtain robust optimal control in a certain environment under certain assumptions. Interestingly, it seems clear that his paper may also provide a powerful tool for positive, or descriptive, purposes. 4 In particular, the last twenty years have witnessed a clear worldwide evolution in central bankers explicit and implicit contracts, toward the targeting of low and stable inflation. 5 This happened without the explicit insights of robust control, the application of which to monetary policy is a comparatively new phenomenon. Instead, it is as if central banks took to heart the insights of Friedman (1959), Lucas (1972), and Sargent and Wallace (1975), among others, eventually recognizing that the optimal contract for a central bank may appropriately put much less weight on output gaps than on inflation gaps, because too little is known about the money-output link to exploit it reliably. That s precisely what Wiliams model says and formalizes: when the natural rate is uncertain, stay away from trying to fine-tune employment, and focus instead on what can actually be achieved low and stable inflation. 4. Final Thoughts To paraphrase a popular wall poster from some years ago, central bankers seeking robust policies need (1) the skill to model quantitatively that which can be modeled quantitatively, (2) the forbearance to avoid attempting to model quantitatively that which can not be modeled quantitatively, and (3) the wisdom to know the difference. The robust control literature has made impressive strides regarding (1). I look forward to similar progress on (2) and (3), which will require explicitly recognizing that some potentially important forms of model uncertainty are 4 For additional perspective on this theme, see Orphanides and Williams (2003). 5 For a colorful and informative portrait, see Bernanke, Laubach, Mishkin and Posen (1999).

unknown and perhaps even unknowable, and hence not amenable to a tidy quantitative minimax analysis over a pre-specified model set. Hopefully, the incomplete contracting perspective, which has proved so successful in areas such as organization and compensation design, will help lead us to central bank contracts robust to model uncertainty of unknown form. 6 References Bernanke, B.S., Laubach, T., Mishkin, F.S. and Posen, A.S. (1999), Inflation Targeting: Lessons From the International Experience. Princeton: Princeton University Press. Diebold, F.X. and Inoue, A. (1998), Long Memory and Regime Switching, Journal of Econometrics, 105, 131-159. Diebold, F.X. and Rudebusch, G.D. (1991), On the Power of Dickey-Fuller Tests Against Fractional Alternatives, Economics Letters, 35, 155-160, Friedman, M. (1959), A Program for Monetary Stability. New York: Fordham University Press. Hansen, L.P. and Sargent, T.J. (2004), Robust Control and Economic Model Uncertainty, Manuscript. King, M. (2004), The Institutions of Monetary Policy, National Bureau of Economic Research, Working Paper No. 10400. Lucas, R.E., Jr. (1972), Expectations and the Neutrality of Money, Journal of Economic Theory, 4, 103-124. Orphanides, A. and Williams, J.C. (2003), The Decline of Activist Stabilization Policy: Natural Rate Misperceptions, Learning, and Expectations, Working Paper, 2003-24, Federal Reserve Bank of San Francisco. Sargent, T.J. and Wallace, N. (1975), Rational Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule, Journal of Political Economy, 83, 241-254. White, H. (2000), A Reality Check for Data Snooping, Econometrica, 68, 1097-1126. 6 For additional insights, see King (2004).