Robustness and U.S. Monetary Policy Experimentation

Abstract

We study how a concern for robustness modifies a policymaker's incentive to experiment. A policymaker has a prior over two submodels of inflation-unemployment dynamics. One submodel implies an exploitable trade-off, the other does not. Bayes' law gives the policymaker an incentive to experiment. The policymaker fears that both submodels and his prior probability distribution over them are misspecified. We compute decision rules that are robust to misspecifications of each submodel and of the prior distribution over submodels. We compare robust rules to ones that Cogley, Colacito, and Sargent (2007) computed assuming that the models and the prior distribution are correctly specified. We explain how the policymaker's desires to protect against misspecifications of the submodels, on the one hand, and misspecifications of the prior over them, on the other, have different effects on the decision rule. © 2008 The Ohio State University.