Robust expectations and uncertain models – A robust control approach with application to the New Keynesian economy

This paper extends Svensson and Woodford’s (2003) partial information framework by allowing the private agents to achieve robustness against incomplete information about the structure of the economy by distorting their expectations in a particular direction. It shows how a linear rational expectations equilibrium under concern for robustness can be solved by exploiting the recursive structure of the problem and appropriately modifying the Bellman equations in their framework. The standard Kalman filter is then used for information updating under imperfect measurement of the state variables. The standard New Keynesian model is used for illustrating how concern for modelling errors interacts with imperfect information. Agents achieve robustness by simultaneously over-estimating the persistence of exogenous shocks, but under-estimating the policy response to the output gap. This under-estimation, combined with imperfect measurement, leads to larger and more persistent responses of private consumption to government expenditure shocks under robust expectations.