Working paper No. 105
By Ben Martin
This paper explores the theoretical implications of parameter uncertainty for the optimal monetary policy reaction function. The policy-maker sets the nominal interest rate to meet an inflation target in a simple dynamic model of the economy. The paper looks at how parameter uncertainty in the transmission mechanism affects the optimal nominal and real interest rate relative to the case when the parameters are known. Its chief contribution is to show that three consequences are identified: conservatism (smaller deviations of real and nominal interest rates from some neutral level in response to inflationary shocks), gradualism (increased autocorrelation in real and nominal interest rates) and caution (a smaller cumulative policy response). The paper examines the sensitivity of these effects to different specifications of the transmission mechanism; in particular the introduction of an exchange rate channel. The paper also considers situations in which a more aggressive response may be called for.
Caution and gradualism in monetary policy under uncertainty