2009), “Imperfect Knowledge and the Pitfalls of Optimal Control Monetary Policy

This paper examines the robustness characteristics of optimal control policies derived under the assumption of rational expectations to alternative models of expectations formation and uncertainty about the natural rates of interest and unemployment. We assume that agents have imperfect knowledge about the precise structure of the economy and form expectations using a forecasting model that they continuously update based on incoming data. We also allow for central bank uncertainty regarding the natural rates of interest and unemployment. We find that the optimal control policy derived under the assumption of rational expectations performs relatively poorly when agents learn. These problems are exacerbated by natural rate uncertainty, even when the central bank’s natural rates are efficient. We then examine to two types of simple monetary policy rules from the literature that have been found to be robust to model misspecification in other contexts. We find that these policies are robust to the alternative models of learning that we study and natural rate uncertainty and outperform the optimal control policy for empirically plausible parameterizations of the learning and natural rates models