Welfare-Maximizing Monetary Policy under Parameter Uncertainty

Edge, Rochelle M.; Laubach, Thomas; Williams, John C.

doi:10.24148/wp2007-11

Working Paper

Welfare-Maximizing Monetary Policy under Parameter Uncertainty

Abstract: This paper examines welfare-maximizing monetary policy in an estimated micro-founded general equilibrium model of the U.S. economy where the policymaker faces uncertainty about model parameters. Uncertainty about parameters describing preferences and technology implies uncertainty about the model’s dynamics, utility-based welfare criterion, and the "natural" rates of output and interest that would prevail absent nominal rigidities. We estimate the degree of uncertainty regarding natural rates due to parameter uncertainty. We find that optimal Taylor rules under parameter uncertainty respond less to the output gap and more to price inflation than would be optimal absent parameter uncertainty. We also show that policy rules that focus solely on stabilizing wages and prices yield welfare outcomes very close to the first-best.

JEL Classification: E5;

https://doi.org/10.24148/wp2007-11