DP6331 Monetary Policy with Model Uncertainty: Distribution Forecast Targeting

Author(s): Lars E O Svensson , Noah Williams

Publication Date: June 2007

Keyword(s): multiplicative uncertainty , Optimal policy

JEL(s): E42 , E52 , E58

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP6331.asp.asp

We examine optimal and other monetary policies in a linear-quadratic setup with a relatively general form of model uncertainty, so-called Markov jump-linear-quadratic systems extended to include forward-looking variables and unobservable "modes." The form of model uncertainty our framework encompasses includes: simple i.i.d. model deviations; serially correlated model deviations; estimable regime-switching models; more complex structural uncertainty about very different models, for instance, backward- and forward-looking models; time-varying central-bank judgment about the state of model uncertainty; and so forth. We provide an algorithm for finding the optimal policy as well as solutions for arbitrary policy functions. This allows us to compute and plot consistent distribution forecasts - fan charts - of target variables and instruments. Our methods hence extend certainty equivalence and "mean forecast targeting" to more general certainty non-equivalence and "distribution forecast targeting."