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Title: Monetary Policy with Model Uncertainty: Distribution Forecast Targeting

Author(s): Lars E.O. Svensson and Noah Williams

Publication Date: June 2007

Keyword(s): multiplicative uncertainty and Optimal policy

Programme Area(s): International Macroeconomics

Abstract: We examine optimal and other monetary policies in a linear-quadratic setup with a relatively general form of model uncertainty, so-called Markov jump-linear-quadratic systems extended to include forward-looking variables and unobservable "modes." The form of model uncertainty our framework encompasses includes: simple i.i.d. model deviations; serially correlated model deviations; estimable regime-switching models; more complex structural uncertainty about very different models, for instance, backward- and forward-looking models; time-varying central-bank judgment about the state of model uncertainty; and so forth. We provide an algorithm for finding the optimal policy as well as solutions for arbitrary policy functions. This allows us to compute and plot consistent distribution forecasts - fan charts - of target variables and instruments. Our methods hence extend certainty equivalence and "mean forecast targeting" to more general certainty non-equivalence and "distribution forecast targeting."

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Bibliographic Reference

Svensson, L and Williams, N. 2007. 'Monetary Policy with Model Uncertainty: Distribution Forecast Targeting'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=6331