RDP 2000-10: Monetary Policy-Making in the Presence of Knightian Uncertainty 7. Conclusions and Further Research

This paper has explored the extent to which Knightian uncertainty can help reconcile differences between interest rate paths generated by models of optimal policy and those observed in practice. We began by providing a framework for discussing different types of uncertainty and the decision rules that they imply.

Recent analyses of model uncertainty have explicitly used minimax decision rules, which directly result from one particular formalisation of Knightian uncertainty. We advocate an alternative formalisation of Knightian uncertainty due to Bewley (1986) that assumes the policy-maker wishes to compare alternatives under all possible probability distributions in order to make their decisions. This formalisation provides monetary policy decision-makers with a range of possibly optimal interest rates which, when combined with intuitively appealing additional decision rules that are consistent with this decision-making environment, can generate paths of interest rates with extended periods of no change. Simulations that include examples of these simple decision rules are used to demonstrate their effects.

Although the results of our simulations are promising, there are several issues that warrant further research. Perhaps most importantly, the algorithm we have proposed is not fully optimal. In particular, we have only investigated two simple sets of decision rules. Another direction of further research is to explore more sophisticated models that contain more realistic lag structures and, perhaps, incorporate a richer set of explanatory variables. We believe extensions along these lines will be fruitful.