The Source of Uncertainty and Optimal Monetary Policy

Abstract

We study whether the source of uncertainty shocks matters for optimal monetary policy, focusing on productivity and cost-push uncertainty shocks. Although both shocks deliver similar macroeconomic dynamics under an empirical Taylor rule, they generate very different dynamics under optimal monetary policy. Following productivity uncertainty shocks, the optimal monetary policy achieves joint stabilization of output gaps and inflation. In contrast, in response to cost-push uncertainty shocks, the monetary authority faces a trade-off between the output gap and inflation stabilization. Our result shows that it is important for welfare-maximizing central banks to distinguish the source of uncertainty shocks.