Monetary Policy Under Uncertainty in Micro-Founded Macroeconometric Models

Abstract

We use a micro-founded macroeconometric modeling framework to investigate the design of monetary policy when the central bank faces uncertainty about the true structure of the economy. We apply Bayesian methods to estimate the parameters of the baseline specification using postwar U.S. data, and then determine the policy under commitment that maximizes household welfare. We find that the performance of the optimal policy is closely matched by a simple operational rule that focuses solely on stabilizing nominal wage inflation. Furthermore, this simple wage stabilization rule is remarkably robust to uncertainty about the model parameters and to various assumptions regarding the nature and incidence of the innovations. However, the characteristics of optimal policy are very sensitive to the specification of the wage contracting mechanism, thereby highlighting the importance of additional research regarding the structure of labor markets and wage determination.

An Estimated DSGE Model of the Indian Economy

“…In particular, the posterior mean estimates for the Calvo price-setting parameter, ξ, imply an average price contract duration of around 2.5 quarters, similar to the findings of Christiano et al (2005), Levin et al (2006) and Smets and Wouters (2007). It is interesting to note that the risk-aversion parameter (σ) is estimated to be slightly greater than assumed in the prior distribution, indicating that the inter-temporal elasticity of substitution (proportional to 1/σ) is estimated to be about 0.54 in the US, which is plausible as suggested in much of RBC literature.…”

“…As shown in Table 2, the estimation results are plausible and are generally similar to those of Levin et al (2006) and Smets and Wouters (2007) for the US. In particular, the posterior mean estimates for the Calvo price-setting parameter, ξ, imply an average price contract duration of around 2.5 quarters, similar to the findings of Christiano et al (2005), Levin et al (2006) and Smets and Wouters (2007).…”

“…Normal distributions are used when more informative priors seem to be necessary. In some cases, we use the same prior means as in previous studies (Levin et al (2006), Smets and Wouters (2003) and Smets and Wouters (2007), for example), but choose larger standard deviations, thus imposing less informative priors and allowing for the data to determine the parameters' location. The first four columns of Table 3 provide an overview of the priors used for each model variant described below in the case of India.…”

The dynamic effects of shocks to wages and prices in the United States and the Euro Area

“…Christiano et al (2005) conclude that stickiness in nominal wages is crucial for the performance of their model, while price stickiness plays a relatively small role. Levin et al (2005) show that the shape of the distribution of wage contracts in staggered wage-setting models matters signi…cantly for monetary policy. In turn, Blanchard and Galí (2007) demonstrate that allowing for real wage rigidities in the standard new Keynesian model the so-called "divine coincidence" disappears and central banks face a trade-o¤ between stabilising in ‡ation and stabilising the welfare relevant output-gap.…”

“…On the theoretical front, recent literature -of which Erceg et al (2000), Christiano et al (2005), Levin et al (2005) and Blanchard and Galí (2007) are some notable examples -has re-a¢ rmed the importance of price and wage rigidities for the evolution of the macro economy in response to shocks. Erceg et al (2000) show that introducing staggered nominal wage setting in addition to staggered price setting in their optimising-agent model changes the conclusions about the optimal monetary policy rules, as opposed to the case when staggered price setting is the sole form of nominal rigidity.…”