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Model Uncertainty in Macroeconomics

For many years, structural macroeconomic models used at central banks for policy evaluation have exhibited New Keynesian features such as nominal rigidities and forward-looking decision-making. More recently, new contributions have added more detailed characterizations of the financial sector. This chapter employs a comparative approach to investigate the characteristics of this new generation of macro-financial models and documents increased model uncertainty. Policy transmission is highly heterogeneous across types of financial frictions and monetary policy has larger effects, on average. A simple policy rule optimized to perform well over several models with financial frictions involves a weaker response to inflation and the output gap than in earlier models. Including a response to financial variables such as credit growth does not improve performance very much, yet a response to output growth does. Models with financial frictions produce somewhat better forecasts. Overall, model-averaging yields a more robust framework for designing monetary policy.