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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

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

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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

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

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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

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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 bank’s 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 bank’s 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

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4

Optimaalinen rahapolitiikka ja robusti säätöteoria

Suomen Pankin keskustelualoitteita 18/2003

Juha Kilponen

Tutkimusosasto

Tiivistelmä

Tässä tutkimuksessa sovelletaan robustia säätöteoriaa optimaalisen rahapolitiikan suunnitteluun tapauksessa, jossa keskuspankin käyttämä talouden malli on epä-varma. Robustissa säätöteoriassa ohjaussäännön tarkkuus pyritään pitämään hyvä-nä mallinnusvirheistä huolimatta. Rahapolitiikan uskottavuusmallilla tehdyt las-kelmat osoittavat, että rahapolitiikan tulisi reagoida aktiivisemmin talouteen tule-viin tarjontasokkeihin, kun keskuspankin malli on epätarkka. Lisäksi inflaatio-harha kasvaa ja tuotannonkuilun ja inflaation välinen yhteys tulee epäedullisem-maksi malliepävarmuuden lisääntyessä. Tämä johtaa siihen, että keskuspankin optimaalinen inflaationsietokyky pienenee malliepävarmuuden kasvaessa.

Avainsanat: robusti säätöteoria, rahapolitiikka, Brainard konservatiivisuus, malli-epävarmuus

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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

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(28)

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(29)

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 462-025-1, print; ISBN 952-462-026-X, online. (TU)

2/2003 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)

3/2003 Johanna Lukkarila Aasian, Venäjän ja Turkin rahoituskriisien vertailua. 2003. 57 p. ISBN 952-462-029-4, print; ISBN 952-462-030-8, online. (KT) 4/2003 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)

5/2003 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)

6/2003 Tuomas Takalo – Otto Toivanen Equilibrium in financial markets with

adverse selection. 2003. 45 p. ISBN 952-462-039-1, print; ISBN 952-462-040-5, online. (TU)

7/2003 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)

8/2003 Hanna Jyrkönen – 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)

9/2003 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)

10/2003 George W. Evans – Seppo Honkapohja Friedman’s money supply rule vs

optimal interest rate policy. 2003. 22 p. ISBN 952-462-049-9, print; ISBN 952-462-050-2, online. (TU)

(30)

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.

References

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