Monetary Policy and Model Uncertainty in a Small Open Economy

We study the effects of optimized monetary policy in a semi-structural, estimated small open economy in situations where the policymaker has either complete or less than complete confidence in the model being free from misspecification errors. We use the robust control techniques developed by Dennis, Leitemo and Söderström (2006). We find that irrespective of the level of confidence to the model, the central bank may reduce loss by more than 80% by making a policy commitment. It is the open-economy channels introduce trade-offs in which commitment enhances policy outcome. If the policymaker lacks confidence in the model specification, a robust policymaker mainly fears that the exchange rate and domestic inflation equations are misspecified. Consequently, the robust policy is designed primarily to counteract these types of potential misspecifications. Policy becomes more aggressive towards all shocks. Although the exchange rate equation provides great opportunities for worst-case distortions, the exchange rate channels also provide ample ways in which policy can counteract distortions to the model, especially under policy commitment. The exchange rate channels can hence be viewed as both a curse and a blessing to the policymaker.