Working Paper BETA #2008-15

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Title : Monetary policy, asset prices and model uncertainty

Author(s) : Meixing DAI, Eleftherios SPYROMITROS

Abstract : Using a macroeconomic model with asset prices, we analyze how optimal monetary policy, and macroeconomic dynamics and performance are affected by the central bank’s desire to be robust against model misspecifications. Considering the worst-case model, we show that an increase in the central bank’s preference for robustness requires a more aggressive reaction of the optimal nominal interest rate with respect to expected inflation and inflation shocks. According to the value of structural parameters, the economic equilibrium can be stable or saddle-point stable. In both cases, the speed of dynamic convergence is smaller under robust control compared to a benchmark case without it. Finally, an increase in the preference for robustness reinforces the reaction of current and expected future inflation, asset prices and output-gap to inflation shocks. However, the preference for robustness has no effect on the reaction of asset prices to the shocks affecting goods demand and financial markets.

Key-words : Monetary policy, asset prices, model uncertainty, macro-financial stability.

JEL Classification : E44, E52, E58.