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Insurance Policies for Monetary Policy in the Euro Area

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  • Keith Kuester

    (European Central Bank)

  • Volker Wieland

    (Goethe University Frankfurt)

Abstract

In this paper, we design a monetary policy for the euro area at the start of monetary union. We compare and ultimately combine Bayesian and worst-case analysis using four reference models developed at the ECB and estimated with pre-EMU synthetic data. We start by computing the cost of insurance against model uncertainty. We find that maximum insurance across this range of models can be obtained at moderate costs relative to a Bayesian policy with flat priors. However, there are three shortcomings of this worst-case insurance policy: (i) prior beliefs indicate that such insurance is strongly oriented towards the model with highest baseline losses; (ii) the Minimax policy is not as tolerant towards small perturbations of policy parameters as the Bayesian policy; and (iii) the Minimax policy offers no avenue for incorporating posterior model probabilities derived from data available since monetary union. Thus, we propose preferences for robust policy design that reflect a mixture of the Bayesian and Minimax approaches. These preferences incorporate model probabilities while still giving extra weight to the worst uncertain outcomes

Suggested Citation

  • Keith Kuester & Volker Wieland, 2008. "Insurance Policies for Monetary Policy in the Euro Area," Discussion Papers 07-044, Stanford Institute for Economic Policy Research.
    • Handle: RePEc:sip:dpaper:07-044
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    More about this item

    Keywords

    model uncertainty; robustness; monetary policy rules; minimax; euro area;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

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