Newspapers and other media outlets regularly speculate about what the Bank of England might do in response to current economic conditions. Curiously, however, most of the models we use to carry out our economic and policy analysis completely disregard this type of uncertainty. Many of them consider how people would behave when uncertain about the state of the economy, yet everyone is assumed to know for sure the variables that the central bank will respond to, how aggressively and why. To try and fill this gap between the models we typically use and the reality we actually face, in our paper we explore the effects of Knightian uncertainty about the behaviour of the policymaker in an otherwise standard macro model.
We think Knightian uncertainty best captures the situation we want to model, because it represents an environment in which agents are not just uncertain about the macroeconomic outcomes, but are also uncertain about the odds of such outcomes. The simplest example is one in which a draw is made from an urn containing red and black balls. If we were told we’d win one pound when a red ball is drawn and we knew half of spheres were actually red, we would clearly be uncertain about our future income, but we would at least know that we stand a 50 percent chance of winning. Knightian uncertainty, on the other hand, refers to the case in which we do not know the share of red balls in the urn, and therefore do not know the odds.
Moving to our macroeconomic application, models usually posit that the central bank will follow a simple Taylor-type rule, which assumes that policymakers respond to deviations of inflation from its target and output from its potential level. Crucially, standard macro models also assume that all agents in the models perfectly know that this is indeed the rule that will determine policy rates at present and in the future.
Interestingly, it turns out that, in this world, the responsiveness of the policy rate to inflation serves as a hedge against the worst consequences of uncertainty. In our simple setup, the inefficiency determined by Knightian uncertainty enters the economy via a suboptimal level of inflation. A stronger response to inflation deviations is a way of reducing the scope for this pernicious effect. But there are clear limits to the extent to which the policy rate can respond to inflation deviating from target, most notably the effective lower bound on interest rates. So reducing the underlying Knightian uncertainty by communication is a way of achieving better macroeconomic outcomes.
Do read the entire thing.