Central Bank Credibility, Perceived Economic Risk, and Simulated Moments

How does perceived economic risk and its interaction with the central bank’s credibility affect monetary policy?
This question will be addressed through the lens of a medium-scale New Keynesian (NK) dynamic stochastic general equilibrium (DSGE) framework, as outlined in the seminal work of Smets and Wouters (2007) (SW), with a particular focus on boundedly rational expectations, as elucidated by De Grauwe (2011). This thesis introduces measures for perceived economic risk and central bank credibility, as well as a more complex approach to model expectation heuristics, with the aim of enhancing the explanatory power of the framework. I contribute to the field by estimating these novel approaches to perceived risk and expectation modeling. With the resulting estimates, I contribute to the ongoing discussion on how the monetary policy stance should change when agents form boundedly rational expectations. The optimized monetary policy responses to varying central bank credibility environments are of particular interest. The estimated model is also used for welfare experiments with the risk and expectation channel components.

The underlying model is able to match the third and fourth moments of real variables. Additionally, the framework, including the risk channel, is better suited to match higher moments than the extended riskless, financial frictions framework. Regarding monetary policy implications, Adding the price of capital and the risk measure as instruments to the monetary policy rule improves welfare in all credibility environments, but the effect is minimal. Lastly, the central bank faces a trade-off within the mandate
to target the share of agents following the deanchoring heuristic. The flexible heuristic targeting objective produces lower output variance but, in turn, higher inflation volatility in low-credibility environments.

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