Research Discussion Papers, Bank of Finland
No 14/1999:
The Effects of Transmission Uncertainty on the Flexibility-Credibility Tradeoff in Monetary Policy
Marc-Alexandre Sénégas ()
and Jouko Vilmunen ()
Abstract: In this paper we address the issue of how parameter
uncertainty affects the optimal degree of central bank conservatism. The
analysis is conducted in the standard macroeconomic model of a monetary
policy game embedding an expectational Phillips-curve. Multiplicative
"Brainard" uncertainty is added to the model. This means that the central
bank's policy instrument has a stochastic impact on inflation. This type of
uncertainty is particularly interesting, since it affects the
credibility–flexibility tradeoff in monetary policymaking. We show that if
the flexibility problem dominates, an increase in uncertainty reduces
optimal conservatism. However, increases in uncertainty can also require
increases in the optimal degree of conservatism. This happens when the
central bank has a sufficiently large credibility problem. This is
particularly clear in the case of the introduction of uncertainty at the
margin. Furthermore, the coefficient of variation of inflation appears to
contain useful information about the relative size of the credibility
problem and, hence, about how incipient uncertainty can affect optimal
conservatism in actual economies.
Keywords: credibility; flexibility; monetary policy; conservatism; uncertainty; (follow links to similar papers)
37 pages, March 8, 1999
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