The role of model uncertainty and learning in the U.S. postwar policy response to oil prices

Abstract

This paper studies optimal monetary policy in a framework that explicitly accounts for policymakers' uncertainty about the channels of transmission of oil prices into the economy. More specifically, I examine the robust response to the real price of oil that US monetary authorities would have been recommended to implement in the period1970-2009; had they used the approach proposed by Cogley and Sargent (2005b) to incorporate model uncertainty and learning into policy decisions. In this context, I investigate the extent to which regulators'changing beliefs over di€erent models of the economy play a role in the policy selection process. The main conclusion of this work is that, in the specific environment under analysis, one of the underlying models dominates the optimal interest rate response to oil prices. This result persists even when alternative assumptions on the models'priors change the pattern of the relative posterior probabilities, and can thus be attributed to the presence of model uncertainty itself.