Robust Monetary Policy in a Model of the Polish Economy: Is the Uncertainty Responsible for the Interest Rate Smoothing Effect?

Abstract

Optimal monetary policy models in the linear–quadratic framework produce high variability of interest rates, and are hence inconsistent with the data where typically interest rate smoothing is observed. In this paper we determine optimal monetary polices in a VAR model of the Polish economy with parameter uncertainty. We prove that there exists a structure of the multiplicative uncertainty in the optimal linear–quadratic model that explains the central bank’s behaviour. Thus proving that parameter uncertainty can be the rationale for “timid” movements in the short-interest rate dynamics. Finally, we show that there is trade off between parameter uncertainty and the interest rate smoothing incentive.