A Bayesian approach to optimal monetary policy with parameter and model uncertainty

Working papers set out research in progress by our staff, with the aim of encouraging comments and debate.
Published on 23 February 2011

Working Paper No. 414
By Timothy Cogley, Bianca de Paoli, Christian Matthes, Kalin Nikolov and Tony Yates

This paper undertakes a Bayesian analysis of optimal monetary policy for the United Kingdom. We estimate a suite of monetary policy models that include both forward and backward-looking representations as well as large and small-scale models. We find an optimal simple Taylor-type rule that accounts for both model and parameter uncertainty. For the most part, backward-looking models are highly fault tolerant with respect to policies optimised for forward-looking representations, while forward-looking models have low fault tolerance with respect to policies optimised for backward-looking representations. In addition, backward-looking models often have lower posterior probabilities than forward-looking models. Bayesian policies therefore have characteristics suitable for inflation and output stabilisation in forward-looking models.

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