DP6067 Monetary Policy in a Small Open Economy with a Preference for Robustness

Author(s): Richard Dennis, Kai Leitemo, Ulf Söderström
Publication Date: January 2007
Keyword(s): model misspecification, model uncertainty, robust control
JEL(s): E52, E61, F41
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6067

We use robust control techniques to study the effects of model uncertainty on monetary policy in an estimated, semi-structural, small-open-economy model of the U.K. Compared to the closed economy, the presence of an exchange rate channel for monetary policy not only produces new trade-offs for monetary policy, but it also introduces an additional source of specification errors. We find that exchange rate shocks are an important contributor to volatility in the model, and that the exchange rate equation is particularly vulnerable to model misspecification, along with the equation for domestic inflation. However, when policy is set with discretion, the cost of insuring against model misspecification appears reasonably small.