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Working Paper Abstract

290.
Robust Monetary Policy in a Small Open Economy

by Kai Leitemo (Norwegian School of Management) and Ulf Soderstrom (IGIER and Bocconi University)

Abstract

This paper studies how a central bank’s preference for robustness against
model misspecification affects the design of monetary policy in a New-Keynesian
model of a small open economy. Due to the simple model structure,
we are able to solve analytically for the optimal robust policy rule, and we
separately analyze the effects of robustness against misspecification concerning
the determination of inflation, output and the exchange rate. We show that
an increased central bank preference for robustness makes monetary policy
respond more aggressively or more cautiously to shocks, depending on the
type of shock and the source of misspecification.

Keywords: Knightian uncertainty, model uncertainty, robust control, minmax
policies.

JEL Classification: E52, E58, F41.

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Last updated February 27, 2007