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Bank of Finland Research Discussion Papers, Bank of Finland

No 18/2003:
A positive theory of monetary policy and robust control

Juha Kilponen ()

Abstract: This paper applies the robust control approach to a simple positive theory of monetary policy, when the central bank’s model of the economy is subject to misspecifications. It is shown that a central bank should react more aggressively to supply shocks when the model misspecifications grow larger. Moreover, the model misspecifications aggravate the inflation bias and a trade-off between output stabilisation and inflation worsens when the uncertainty surrounding the central bank’s model increases. This implies that the larger the model misspecifications are, the more inflation-averse the central bank should be.

Keywords: risk-sensitivity; robust control theory; monetary policy; Brainard conservatism; model uncertainty; (follow links to similar papers)

JEL-Codes: E58; (follow links to similar papers)

30 pages, August 12, 2003

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