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A NOTE ON MONETARY POLICY, ASSET PRICES, AND MODEL UNCERTAINTY

Published online by Cambridge University Press:  25 January 2012

Meixing Dai  and
Eleftherios Spyromitros
Meixing Dai*
Affiliation:
BETA, University of Strasbourg
Eleftherios Spyromitros
Affiliation:
BETA, University of Strasbourg and Demokritus University of Thrace
*
Address correspondence to: Meixing Dai, BETA, University of Strasbourg, 61, avenue de la Forêt Noire, 67085 Strasbourg Cedex, France; e-mail: dai@unistra.fr.
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Abstract

Using a macroeconomic model with asset prices, we analyze how optimal monetary policy and macroeconomic dynamics and performance are affected by a central bank's desire to be robust against model misspecifications. We show that a higher central bank preference for robustness implies a more aggressive reaction of the nominal interest rate to the expected future inflation rate and inflation shocks. The dynamic stability of the equilibrium is not modified for a sufficiently high preference for robustness. However, the speed of dynamic convergence is lower under robust control compared to a benchmark case without it and implies supplementary economic costs. Finally, an increase in the preference for robustness comes at the cost of higher macroeconomic and financial volatility in the presence of inflation shocks. It has no effect on the reaction of inflation, output gap, and asset price gap to shocks affecting goods and financial markets.

Keywords

Monetary PolicyAsset PricesModel UncertaintyMacro-financial Stability
Type
Notes
Information
Macroeconomic Dynamics , Volume 16 , Issue 5 , November 2012 , pp. 777 - 790
Copyright
Copyright © Cambridge University Press 2012

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