DP6331 Monetary Policy with Model Uncertainty: Distribution Forecast Targeting

Author(s): Lars E.O. Svensson, Noah Williams
Publication Date: June 2007
Keyword(s): multiplicative uncertainty, Optimal policy
JEL(s): E42, E52, E58
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6331

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."