Should Macroeconomic Policy Makers Consider Parameter Covariances?

Hans M. Amman - University of Amsterdam and David Kendrick - University of Texas

Macro economic policy exercises commonly consider the mean values of parameter estimates but do not use the variances and covariances. One can argue that the uncertainty of the parameter estimates is sufficiently small that it can safely be ignored. Or one can take the position that this kind of uncertainty cannot be avoided no matter what one does and thus may as well be ignored while making policy decisions.

In this paper we address both of these positions and find evidence that they are lacking. We provide a small model example which suggests that (1) the uncertainty of parameter values in the U.S. economy is sufficiently great that it cannot be safely ignored and (2) a method is available for considering parameter uncertainty which can improve on policy outcomes. The method is the passive learning (or open loop feedback) method from control theory. Over Monte Carlo runs this method makes relatively less use of those policy measures which have a channel of effect including variables whose parameters are more uncertainty. Thus the uncertainty in the outcomes is reduced.

Scheduled for Session 1.3 Optimum Policy Making Under Uncertainity