Optimal Interest Rate Smoothing under Model Ambiguity

We solve for the equilibrium of a standard real business cycle model with money under model ambiguity.

Author(s):

Abraham Lioui

Professor of Finance, EDHEC Risk and Asset Management Research Centre

Patrice Poncet

PRISM, Faculty of Management, University of Paris 1 Panthéon-SorbonneFinance Department, ESSEC Business School, France.

We first show that monetary certainty is a sufficient condition for an interest rate smoothing rule to be optimal even under preferences for model robustness on the part of private agents. We then derive the necessary and sufficient condition for a stochastic (but stationary) monetary policy to reproduce the equilibrium of the real economy and compute the optimal (constant) level of the nominal interest rate. The condition implies a monetary policy conducted in such a way that the effects of shocks due to the randomness of the money growth rate on private agents' optimal consumption are nullified. We also provide some positive empirical evidence as to the realism of this condition for the U.S. economy in recent years. We show that, without model ambiguity, the coefficient of risk aversion must, at the empirical level, be unrealistically large so as to make a constant interest rate rule optimal. Introducing a preference for robustness decreases the required risk aversion coefficient dramatically.

Type: Working paper
Date: le 07/09/2009
Research Cluster : Finance

See Also

The EDHEC case study “Maison Maille” won the 2018 Emerald Best Case Award
News
- 17-05-2019
We are very proud to announce that “Maison Maille: making mustard aspirational to...
EDHEC Tomorrow - Horizon 2030
News
- 16-05-2019
As part of the preparation of the 2020-2025 strategic plan, we wish to open the debate...
Start-Up and Innovation in the Sun – Welcome to the Cote d’Azur!
News
- 15-05-2019
The Cote d’Azur in the south of France is well-known for its warm climate, 120...
Entrepreneurship Track: Hands-On Learning, Insights & Innovation by Renato Figueroa, MBA Candidate
News
- 15-05-2019
A unique feature of the Global MBA programme at EDHEC is the specialization track....