Can monetary policy survive policy model mis‐specification? Model uncertainty and the perils of “policy model complacency”

Abstract

AbstractThe question addressed in this paper is: can monetary policy succeed in stabilizing the economy even when the policy model on which it is predicated is mis‐specified? Using variants of the 3‐equation macroeconomic model, it is shown that this question can be answered in the affirmative. The purpose of the paper is not to encourage indifference toward model uncertainty, however, but rather to warn against the perils of “policy model complacency.” This arises if the success of policy is misinterpreted as successful understanding of the workings of the economy, which makes the policy maker vulnerable to surprises: events with systematic origins in the “true” model of the economy that are not anticipated by the (mis‐specified) policy model. To safeguard against this problem, policy makers should always entertain eclectic views of the workings of the economy. This task is easily accomplished by paying attention to heterodox macroeconomics, which frequently makes predictions that are very much at variance with those of the dominant policy model.