Monetary Policy Under Time-Varying Uncertainty Aversion

In this paper we develop a framework to analyze the optimal policy of an inflation-targeting monetary authority that is not fully confident about its model and the degree of mistrust changes over time as the structure of the economy changes. These changes can include structural breaks as well as price, output or real exchange shocks. We use robust control to denote the degree of uncertainty aversion of the policy maker and a Markov chain to capture the time-varying nature of the uncertainty aversion. We find that in general a more aggressive interest rate policy is the optimal response to: (i) more uncertainty aversion and (ii) higher likelihood that the uncertainty aversion may appear in the future. Moreover, we find that the policy maker’s welfare decreases when there is an increase in uncertainty aversion. However, the transition probabilities in the Markov-chain have ambiguous effects on the policy maker expected losses. Copyright Springer Science+Business Media, LLC. 2013