DP4909 Parameter Instability, Model Uncertainty and the Choice of Monetary Policy

Author(s): Carlo A. Favero, Fabio Milani
Publication Date: February 2005
Keyword(s): model uncertainty, optimal monetary policy, parameter instability
JEL(s): E44, E52, F41
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4909

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.