Robust monetary policy in a small open economy |
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Authors: | Kai Leitemo Ulf Sderstrm |
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Institution: | aDepartment of Economics, Norwegian School of Management (BI), 0442 OSLO, Norway;bDepartment of Economics and IGIER, Bocconi University, Via Salasco 5, 20136 Milan, Italy and CEPR |
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Abstract: | We study how a central bank in a small open economy should conduct monetary policy if it fears that its model is misspecified. Using a new-Keynesian model of a small open economy, we solve analytically for the optimal robust policy rule and the equilibrium dynamics, and we separately analyze the consequences of central bank robustness against misspecification concerning the determination of inflation, output, and the exchange rate. We show that an increase in the preference for robustness makes the central bank respond more aggressively or more cautiously to shocks, depending on the type of shock and the source of misspecification. |
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Keywords: | Model uncertainty Knightian uncertainty Robust control Minmax policies |
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