Robust monetary policy in the micro-founded two-country model of currency union Olga Kuznetsova National Research University Higher School of Economics, Moscow, Russia

Contents Motivation Literature Model Model uncertainty Results

Motivation Theoretical models always differ from the reality The policymaker must take this fact into account when he tries to elaborate an optimal policy on a base of some theoretical model Robust policy is a policy that takes account for such model uncertainty Question: Is robust policy more prudent or more aggressive in comparison with the standard optimal policy on a base of one reference model?

Literature Robust monetary policy, one reference model approach: Brainard (1967) – robust monetary policy under model uncertainty is more prudent Hansen, Sargent (2001) – robust control, robust policy characteristics depends crucially on the uncertainty extent Onatski (2002) - robust monetary policy under model uncertainty is more aggressive Robust monetary policy in EMU – area-wide models with aggregated data only: Altavilla, Ciccarelli (2008) – necessity of robust policy constraction Bihan, Sahuc (2002) – prudent robust policy Žaković, Wieland, Rustem (2005) – prudent robust policy

Model - Benigno (2004) Currency union of two regions: H et F n – economic size of region H; (1-n) – an economic size of region F Each household consumes the products of all firms and produce one unique good All goods are imperfect substitutes The task of a household is to maximise its utility function subject to the budget constraint: - agent’s index - country’s index (or ) - consumption index - stock of real balances - supply of a differentiated good 5

Model - Benigno (2004) Firms act as monopolistic competitors of Calvo type Each period a seller faces the probability of price change. This probability is higher in F region Fiscal policy (tax rates, transfers and government spendings) are defined by regional governemens independently and are taken as exogenous Monetary policy is elaborated by the Central Bank of Union CB chooses the value of nominal interest rate in order to maximize social welfare - weighted average output - terms of trade under sticky prices - terms of trade under flexible prices - inflation in region H - inflation in region F 6

Model: CB’s problem IS curve Terms of trade dynamics Phillips curve H region Phillips curve F region Backward-looking component of terms of trade under flexible prices

Model Uncertainty Reference model: , where z – vector of forward-looking variables: Uncertainty or strategic shocks imposed by malevolent agent: Robust control problem:

Results An optimal robust policy is reaction of nominal interest rate on the values of predetermined variables and shadow prices of forward-looking variables We are interested in coefficient – reaction to the shocks We measure policy aggressiveness by the modulus of this coefficient Solving robust program we use the following redefinition: when uncertainty rises, rises and decreases Aggressiveness of the policy reaction to economic shocks increases with the rise in misspecification fear

Results: weighted average difference in welfare under robust policy and under simple optimal one Robust policy implies substantial welfare gains for society

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