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Optimal monetary policy for a pessimistic central bank

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  • Vitale, Paolo

Abstract

We consider the impact of pessimism on monetary policy within a model with backward-looking expectations and persistence in the dynamics of output and inflation. Pessimistic monetary authorities behave as if they believed that the worst economic conditions were very likely and move the policy instrument to hedge against their negative consequences. With respect to their risk-neutral counterparts, they apply a more aggressive Taylor rule, reducing the inflation rate volatility. The impact of pessimism on monetary policy is magnified by economic uncertainty. A calibration exercise for the U.S. economy confirms the relevance of pessimism as it shows that pessimistic monetary authorities react to a one-standard-deviation supply shock moving the policy instrument by about one percent more than their risk-neutral counterparts. Our conclusions also hold when the monetary authorities observe inflation and output with a time lag.

Suggested Citation

  • Vitale, Paolo, 2018. "Optimal monetary policy for a pessimistic central bank," Journal of Macroeconomics, Elsevier, vol. 58(C), pages 39-59.
    • Handle: RePEc:eee:jmacro:v:58:y:2018:i:c:p:39-59
    DOI: 10.1016/j.jmacro.2018.08.005
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    More about this item

    Keywords

    Monetary policy; Pessimism; Discounted linear exponential quadratic Gaussian;
    All these keywords.

    JEL classification:

    • C61 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Optimization Techniques; Programming Models; Dynamic Analysis
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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