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BANK OF FINLAND DISCUSSION PAPERS

18 2003 Juha Kilponen


Research Department 12.8.2003

A positive theory of monetary policy and robust control

Suomen Pankin keskustelualoitteita Finlands Banks diskussionsunderlag

Suomen Pankki Bank of Finland P.O.Box 160 FIN-00101 HELSINKI Finland ( + 358 9 1831 http://www.bof.fi

BANK OF FINLAND DISCUSSION PAPERS

18 2003 Juha Kilponen


Research Department 12.8.2003

A positive theory of monetary policy and robust control

The views expressed are those of the author and do not necessarily reflect the views of the Bank of Finland.

* E-mail: juha.kilponen@bof.fi This paper was initiated when I was honorary visiting fellow at the City University Business School in London in 2001. I am indebted to Mark Salmon for introducing me to this topic and for many useful comments. I would like to thank seminar participants at the University of Warrick, University of Cambridge and Bank of England for many useful suggestions. I am also indebted to David Mayes and Jouko Vilmunen from the Bank of Finland for their insights and encouragement. Financial support of Academy of Finland (grant No: 49709 is greatly acknowledged. Usual disclaimer applies.

Suomen Pankin keskustelualoitteita Finlands Banks diskussionsunderlag

http://www.bof.fi ISBN 952-462-071-5 ISSN 0785-3572 (print) ISBN 952-462-072-3 ISSN 1456-6184 (online) Suomen Pankin monistuskeskus Helsinki 2003

A positive theory of monetary policy and robust control


Bank of Finland Discussion Papers 18/2003
Juha Kilponen Research Department

Abstract
This paper applies the robust control approach to a simple positive theory of monetary policy, when the central banks model of the economy is subject to misspecifications. It is shown that a central bank should react more aggressively to supply shocks when the model misspecifications grow larger. Moreover, the model misspecifications aggravate the inflation bias and a trade-off between output stabilisation and inflation worsens when the uncertainty surrounding the central banks model increases. This implies that the larger the model misspecifications are, the more inflation-averse the central bank should be. Key words: risk-sensitivity, robust control theory, monetary policy, Brainard conservatism, model uncertainty JEL classification numbers: E58

Optimaalinen rahapolitiikka ja robusti stteoria


Suomen Pankin keskustelualoitteita 18/2003
Juha Kilponen Tutkimusosasto

Tiivistelm
Tss tutkimuksessa sovelletaan robustia stteoriaa optimaalisen rahapolitiikan suunnitteluun tapauksessa, jossa keskuspankin kyttm talouden malli on epvarma. Robustissa stteoriassa ohjaussnnn tarkkuus pyritn pitmn hyvn mallinnusvirheist huolimatta. Rahapolitiikan uskottavuusmallilla tehdyt laskelmat osoittavat, ett rahapolitiikan tulisi reagoida aktiivisemmin talouteen tuleviin tarjontasokkeihin, kun keskuspankin malli on eptarkka. Lisksi inflaatioharha kasvaa ja tuotannonkuilun ja inflaation vlinen yhteys tulee epedullisemmaksi malliepvarmuuden lisntyess. Tm johtaa siihen, ett keskuspankin optimaalinen inflaationsietokyky pienenee malliepvarmuuden kasvaessa. Avainsanat: robusti stteoria, rahapolitiikka, Brainard konservatiivisuus, malliepvarmuus JEL-luokittelu: E58

Contents
Abstract ....................................................................................................................3 1 Introduction ......................................................................................................7 2 Theoretical preliminaries ................................................................................9 3 Application......................................................................................................11 3.1 Preliminaries of the model.......................................................................11 3.2 Discretion.................................................................................................13 3.3 Robustness ...............................................................................................15 4 Discretion and inflation bias .........................................................................17 4.1 Preliminaries ............................................................................................17 4.2 Delegation once more ..............................................................................20 5 Conclusions .....................................................................................................22 References..............................................................................................................24

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59

BANK OF FINLAND DISCUSSION PAPERS ISSN 0785-3572, print; ISSN 1456-6184, online 1/2003 Tanai Khiaonarong Payment systems efficiency, policy approaches, and the role of the central bank. 2003. 69 p. ISBN 952-462-025-1, print; ISBN 952462-026-X, online. (TU) Iftekhar Hasan Heiko Schmiedel Do networks in the stock exchange industry pay off? European evidence. 2003. 44 p. ISBN 952-462-027-8, print; ISBN 952-462-028-6, online. (TU) Johanna Lukkarila Aasian, Venjn ja Turkin rahoituskriisien vertailua. 2003. 57 p. ISBN 952-462-029-4, print; ISBN 952-462-030-8, online. (KT) Samu Peura Esa Jokivuolle Simulation-based stress testing of banks regulatory capital adequacy. 2003. 41 p. ISBN 952-462-035-9, print; ISBN 952-462-036-7, online. (RM) Peik Granlund Economic evaluation of bank exit regimes in US, EU and Japanese financial centres. 2003. 60 p. ISBN 952-462-037-5, print; ISBN 952-462-038-3, online. (TU) Tuomas Takalo Otto Toivanen Equilibrium in financial markets with adverse selection. 2003. 45 p. ISBN 952-462-039-1, print; ISBN 952-462-0405, online. (TU) Harry Leinonen Restructuring securities systems processing a blue print proposal for real-time/t+0 processing. 2003. 90 p. ISBN 952-462-041-3, print; ISBN 952-462-042-1, online. (TU) Hanna Jyrknen Heli Paunonen Card, Internet and mobile payments in Finland. 2003. 45 p. ISBN 952-462-043-X, print; ISBN 952-462-044-8, online. (RM) Lauri Kajanoja Money as an indicator variable for monetary policy when money demand is forward looking. 2003. 35 p. ISBN 952-462-047-2, print; ISBN 952-462-048-0, online. (TU)

2/2003

3/2003

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7/2003

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9/2003

10/2003 George W. Evans Seppo Honkapohja Friedmans money supply rule vs optimal interest rate policy. 2003. 22 p. ISBN 952-462-049-9, print; ISBN 952-462-050-2, online. (TU)

11/2003 Anssi Rantala Labour market flexibility and policy coordination in a monetary union. 2003. 48 p. ISBN 952-462-055-3, print; ISBN 952-462-056-1, online. (TU) 12/2003 Alfred V. Guender Optimal discretionary monetary policy in the open economy: Choosing between CPI and domestic inflation as target variables. 2003. 54 p. ISBN 952-462-057-X, print; ISBN 952-462-058-8, online. (TU) 13/2003 Jukka Vauhkonen Banks equity stakes in borrowing firms: A corporate finance approach. 2003. 34 p. ISBN 952-462-059-6, print; ISBN 952-462-060-X, online. (TU) 14/2003 Jukka Vauhkonen Financial contracts and contingent control rights. 2003. 33 p. ISBN 952-462-061-8, print; ISBN 952-462-062-6, online. (TU) 15/2003 Hanna Putkuri Cross-country asymmetries in euro area monetary transmission: the role of national financial systems. 114 p. ISBN 952-462-063-4, print; ISBN 952-462-064-2, online. (RM) 16/2003 Kari Kemppainen Competition and regulation in European retail payment systems. 69 p. ISBN 952-462-065-0, print; ISBN 952-462-066-9, online. (TU) 17/2003 Ari Hyytinen Tuomas Takalo Investor protection and business creation. 32 p. ISBN 952-462-069-3, print; ISBN 952-462-070-7, online. (TU) 18/2003 Juha Kilponen A positive theory of monetary policy and robust control. 26 p. ISBN 952-462-071-5, print; ISBN 952-462-072-3, online. (TU)