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PARAMETER UNCERTAINTY AND NONLINEAR MONETARY POLICY RULES

Published online by Cambridge University Press:  10 February 2010

Peter Tillmann
Peter Tillmann*
Affiliation:
Justus Liebig University Giessen
*
Address correspondence to: Peter Tillmann, Department of Economics, Justus Liebig University Giessen, Licher Str. 62, D-35394 Giessen, Germany; e-mail: peter.tillmann@wirtschaft.uni-giessen.de.
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Abstract

Empirical evidence suggests that the instrument rule describing the interest rate–setting behavior of the Federal Reserve is nonlinear. This paper shows that optimal monetary policy under parameter uncertainty can motivate this pattern. If the central bank is uncertain about the slope of the Phillips curve and follows a min–max strategy to formulate policy, the interest rate reacts more strongly to inflation when inflation is further away from target. The reason is that the worst case the central bank takes into account is endogenous and depends on the inflation rate and the output gap. As inflation increases, the worst-case perception of the Phillips curve slope becomes larger, thus requiring a stronger interest rate adjustment. Empirical evidence supports this form of nonlinearity for post-1982 U.S. data.

Keywords

Parameter UncertaintyRobust ControlNonlinear Taylor RuleOptimal Monetary PolicyFederal Reserve Policy
Type
Articles
Information
Macroeconomic Dynamics , Volume 15 , Issue 2 , April 2011 , pp. 184 - 200
Copyright
Copyright © Cambridge University Press 2010

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