Abstract :
Model uncertaintyhasthepotentialtochangeimportantlyhowmonetarypolicyis
conducted,makingitanissuethatcentralbankscannotignore.Usingastandardnew
Keynesianbusinesscyclemodel,thispaperanalyzesthebehaviorofacentralbankthat
conductspolicyunderdiscretionwhilefearingthatitsmodelismisspecified.Themain
results areasfollows.First,policyperformancecanbeimprovedifthediscretionary
centralbankimplementsarobustpolicy.Thisimportantresultisobtainedbecausethe
centralbank’sdesireforrobustnessdirectsittoassertivelystabilizeinflation,thereby
mitigatingthestabilizationbiasassociatedwithdiscretionarypolicymaking.Second,
the centralbank’sfearofmodelmisspecificationleadsittoforecastfutureoutcomes
under thebeliefthatinflation(inparticular)willbepersistentandhavelarge
unconditionalvariance,raisingtheprobabilityofextremeoutcomes.Privateagents,
however,anticipatingthepolicyresponse,makedecisionsunderthebeliefthatinflation
will bemorecloselystabilized,thatis,moretightlydistributed,thanunderrational
expectations.Finally,asatechnicalcontribution,thepapershowshowtosolvewith
robustnessanimportantclassoflinear-quadraticdecisionproblems
