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Robust monetary policy under shock uncertainty

Working paper 793
Working Papers

Gepubliceerd: 10 oktober 2023

We assess the robustness of monetary policy under shock uncertainty based on a novel empirical method. Shock uncertainty arises from the inability to observe the output gap in real time, by which the contribution of supply and demand shocks to inflation is unknown. We apply our method in a medium-scale Dynamic Stochastic General Equilibrium (DSGE) model to the recent inflation surge in the US. We find that robust monetary policy aimed at limiting extreme welfare losses under shock uncertainty should neither be too strong nor too mild, given the probability that supply shocks are a dominant driver of economic fluctuations. An overly strong response to inflation in supply driven scenarios is associated with large tail losses due to adverse output dynamics.

Keywords: Monetary policy; Inflation; Policy-making under risk and uncertainty
JEL codes E52; E58; D81

Working paper no. 793

793 - Robust monetary policy under shock uncertainty

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Research highlights

  • Monetary policy faces fundamental uncertainty if the contribution of supply and demand shocks to inflation is unknown because output gap estimates are uncertain.
  • Based on a novel empirical method we generate scenarios to discover the possible combinations of shocks that explain high inflation.
  • The scenarios are applied in a Dynamic Stochastic General Equilibrium (DSGE) model to produce distributions of welfare losses.
  • The loss distributions are useful to design robust monetary policy aimed at limiting extreme welfare losses.

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