Optimal Policy Implications of Financial Uncertainty

The last decades proved that policymaking without considering uncertainty is impracticable. We propose a robust optimal policy under uncertainty in response to financial and inflation shocks by acknowledging financial stability as an explicit monetary policy objective. To do so, we augment a financial DSGE model with model misspecification. We show that model ambiguity on the financial side requires a passive monetary policy stance. However, if the uncertainty originates from the supply side of the economy, an aggressive response of interest rate is required. We also show the impact of an additional macroprudential tool on the dynamics of the economy.