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

2. Contents
Motivation
Literature
Model
Model uncertainty
Results

3. 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?

4. 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

5. 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

6. 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

7. 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

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

9. 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

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

11. Thank you for your attention!