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Monetary Policy and Uncertainty about the Natural Unemployment Rate

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Wieland, Volker

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Abstract

Inflation-targeting central banks have only imperfect knowledge about the effect of policy decisions on inflation. An important source of uncertainty is the relationship between inflation and unemployment. This Paper studies the optimal monetary policy in the presence of uncertainty about the natural unemployment rate, the short-run inflation-unemployment trade-off and the degree of inflation persistence in a simple macroeconomic model, which incorporates rational learning by the central bank as well as private sector agents. Two conflicting motives drive the optimal policy. In the static version of the model, uncertainty provides a motive for the policymaker to move more cautiously than they would if they knew the true parameters. In the dynamic version, uncertainty also motivates an element of experimentation in policy. I find that the optimal policy that balances the cautionary and activist motives typically exhibits gradualism, that is, it still remains less aggressive than a policy that disregards parameter uncertainty. Exceptions occur when uncertainty is very high and inflation close to target.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3811.

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Date of creation: Mar 2003
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Handle: RePEc:cpr:ceprdp:3811

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Related research
Keywords: inflation targeting; monetary policy; natural unemployment rate; optimal learning; parameter uncertainty;

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Find related papers by JEL classification:
C61 - Mathematical and Quantitative Methods - - Mathematical Methods and Programming - - - Optimization Techniques; Programming Models; Dynamic Analysis
D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
E24 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Employment; Unemployment; Wages; Intergenerational Income Distribution
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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