MODEL UNCERTAINTY, ROBUST POLICIES, AND THE VALUE OF COMMITMENT

Abstract

Using results from the literature on H^∞ control, this paper incorporates model uncertainty into a frequency-domain approach to stabilization policy. The derived policies guarantee a minimum performance level even in the worst of (a bounded set of) circumstances. Robust H^∞ policies are shown to be more “activist” than H² policies in the sense that their impulse responses are larger. Robust policies also tend to be more autocorrelated. Consequently, the premium associated with being able to commit is greater under model uncertainty. Without commitment, the policymaker is not able to (credibly) smooth his response to the degree that he would like. A contribution of this paper is its analysis of robust control in a model featuring a forward-looking state transition equation, which arises from the fact that the private sector bases its decisions on expectations of future government policy. Existing applications of H^∞ control in economics follow the engineering literature, and only consider backward-looking state transition equations.