Parameter Instability, Model Uncertainty and the Choice of Monetary Policy

33 Pages Posted: 2 Jun 2005

See all articles by Carlo A. Favero

Carlo A. Favero

Bocconi University - Department of Finance; Centre for Economic Policy Research (CEPR)

Fabio Milani

University of California, Irvine - Department of Economics

Date Written: February 2005

Abstract

This paper starts from the observation that parameter instability and model uncertainty are relevant problems for the analysis of monetary policy in small macroeconomic models. We propose to deal with these two problems by implementing a novel 'thick recursive modelling' approach. At each point in time, we estimate all models generated by the combinations of a base-set of k observable regressors for aggregate demand and supply. We compute optimal monetary policies for all possible models and consider alternative ways of summarizing their distribution. Our main results show that thick recursive modelling delivers optimal policy rates that track the observed policy rates better than the optimal policy rates obtained under a constant parameter specification, with no role for model uncertainty.

Keywords: Model uncertainty, parameter instability, optimal monetary policy

JEL Classification: E44, E52, F41

Suggested Citation

Favero, Carlo A. and Milani, Fabio, Parameter Instability, Model Uncertainty and the Choice of Monetary Policy (February 2005). Available at SSRN: https://ssrn.com/abstract=734425

Carlo A. Favero (Contact Author)

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

HOME PAGE: http://www.igier.unibocconi.it\favero

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Fabio Milani

University of California, Irvine - Department of Economics ( email )

3151 Social Science Plaza
Irvine, CA 92697-5100
United States

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