IMPERFECT OBSERVATION AND SYSTEMATIC POLICY ERROR

This paper assesses the quantitative significance of the systematic policy errors resulting from optimal policy responses to imperfect information. The policy response mechanism is provided by the solution to the linear-quadratic control problem with additive model disturbances an4 noisy observations on the current state of the economy. The policy is implemented using a small quarterly U.S. macro model and observation error " covariance matrix estimates from NIA revisions data. Pairs of simulations are run with one model equation at a time being shocked. In the first run of the pair, exact observations are used in determining the policy response. In the second run, exact observations again are used, but the Kalman. filter is employed as if the observations were subject to error. Thus, we are able to focus on the systematic differences in the time paths of both policy and endogenous variables resulting from the differences between appropriate responses to exact and to imperfect data. This paper assesses the quantitative significance of the systematic ten-dency toward delayed policy response to economic developments implied by an optimal response to imperfect data. In setting policy, the policy-maker responds to incoming data reflecting economic developments