Board of Governors of the Federal Reserve System

January 2001

Activist vs. Non-Activist Monetary Policy: Optimal Rules Under Extreme Uncertainty

Peter von zur Muehlen

Abstract:

The paper was motivated by Milton Friedman’s remark that economists and policy makers know too little about their models to make them useful for setting monetary policy. Therefore, instead of varyingmoney supply (the policy instrument of the day) in response to observed changes in economic aggregates, central banks should determine a constant rate of money growth, a CMG, and stick to it. I viewed this conclusion as too extreme, since it was well known that classical characterizations of model uncertainty would not, except in an extreme version of policy multiplier uncertainty analyzed by Brainard (1967), produce non-reactive policy. I considered, therefore, the possibility that Friedman had something far more extreme than Bayesian risk in mind, a kind of uncertainty that could not be described in terms of subjective or objective probability distributions. This was the idea of uncertainty made famous by Frank H. Knight, which required an entirely different approach to optimization. Since one cannot formalize Knightian uncertainty with well defined probability distributions in a Bayesian sense, it is impossible to formulate policy based on mathematical expectations, obliging the decision maker to resort to minimax strategies that seek to avoid worst-case outcomes.

Keywords: Monetary policy. model uncertainty, minimax strategies, signal detection, Bayes' risk, Bayesian policy

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