Welfare-Maximizing Monetary Policy under Parameter Uncertainty

This paper examines welfare-maximizing monetary policy in an estimated dynamic stochastic general equilibrium model of the U.S. economy where the policymaker faces uncertainty about the true values of model parameters. Uncertainty about parameters describing preferences and technology implies not only uncertainty about model dynamics but also uncertainty about the “natural” level of output that the central bank should aim to achieve. We analyze the characteristics and performance of alternative monetary policy rules given the estimated covariance of parameter estimates. We find that the natural rates of output is very imprecisely estimated. We then show that policy rules that rely on the output gap and therefore estimates estimates of the natural rate of output perform poorly under parameter uncertainty. Instead, optimal policies respond primarily to indirect signals regarding natural rates extracted from observed prices and wages.