Model Uncertainty. Learning, and the Gains from Coordination

Abstract

This paper considers gains from international economic policy coordination when there is uncertainty concerning the functioning of the world economy but also learning about the "true" model on the part of policymakers. The paper reports estimates of plausible alternative versions of a standard two-country model. Activist policy (either coordinated or uncoordinated) may produce large welfare losses in the absence of learning, if policymakers believe in the wrong model; hence, exogenous money targets and freely flexible exchange rates may be best. However, model learning (from observations on macroeconomic variables) causes coordinated policies to dominate activist uncoordinated policies or exogenous money targets.