Imperfect credibility and robust monetary policy

Abstract

This paper studies the behavior of a central bank that seeks to conduct policy optimally while having imperfect credibility and harboring doubts about its model. Taking the Smets–Wouters model as the central bank׳s approximating model, the paper׳s main findings are as follows. First, a central bank׳s credibility can have large consequences for how policy responds to shocks. Second, central banks that have low credibility can benefit from a desire for robustness because this desire motivates the central bank to follow through on policy announcements that would otherwise not be time-consistent. Third, even relatively small departures from perfect credibility can produce important declines in policy performance. Fourth, the risk premium shock represents an important potential source of model misspecification. Finally, as a technical contribution, the paper develops a numerical procedure to solve the decision-problem facing an imperfectly credible policymaker that seeks robustness.