Monetary Policy-making in the Presence of Knightian Uncertainty

This paper explores the extent to which Knightian uncertainty can explain features of interest rate paths observed in practice that are not generally replicated by models of optimal monetary policy. Interest rates tend to move in a sequence of steps in a given direction, or remain constant for some time, rather than experiencing the frequent reversals that commonly arise from optimal policy simulations. We categorise the types of uncertainty that have been explored to date in terms of the decision-making behaviour they imply. From this, we suggest a more intuitively appealing formulation of Knightian uncertainty than the one that has previously been used in the analysis of monetary policy. Within a very simple optimal control problem, we show that our preferred formalisation is consistent with interest rate paths with periods of no change. This suggests that the presence of Knightian uncertainty may explain some features of monetary policy-makers’ behaviour.