Model Uncertainty and Policy Design

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This article illustrates the main challenges and forces that emerge in optimal policy design when there are doubts about the probability model of uncertainty. Model doubts can stem from either the side of the public or the side of the policymaker, and they can give rise to cautious probabilistic assessments. A basic idea that surfaces in setups with model uncertainty is the management of the public's pessimistic expectations by the policymaker. The article also presents several implications of this idea.

Key findings:

  • Both the public and governments struggle with model uncertainty, especially in unprecedented times.
  • Lack of confidence in the probability model of the economy gives rise to cautious probabilistic assessments by all economic actors.
  • Policymakers can affect the course of the economy by managing the public's pessimistic expectations. Depending on the application, they may mitigate or amplify the public's pessimism.

Center for Quantitative Economic Research

JEL classification: D80, E62, H21, H63

Key words: Model uncertainty, ambiguity aversion, multiplier preferences, misspecification, pessimistic expectations, paternalism, taxation, austerity, competitive fringe link

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