Real-time optimal monetary policy with undistinguishable model parameters and shock processes uncertainty

Abstract This paper studies optimal real-time monetary policy when the central bank takes the exogenous volatility of the output gap and inflation as proxy of the undistinguishable uncertainty on the exogenous disturbances and the parameters of its model. The paper shows that when the exogenous volatility surrounding a specific state variable increases, the optimal policy response to that variable should increase too, while the optimal response to the remaining state variables should attenuate or be unaffected. In this way the central bank moves preemptively to reduce the risk of large deviations of the economy from the steady state that would deteriorate the distribution forecasts of the output gap and inflation. When an empirical test is carried out on the US economy the model predictions tend to be consistent with the data.