Doubts about the Model and Optimal Policy

Anastasios G. Karantounias
Working Paper 2020-12
July 2020

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Abstract: This paper analyzes optimal policy in setups where both the leader and the follower have doubts about the probability model of uncertainty. I illustrate the methodology in two environments: a) an industry populated with a large firm and many small firms in a competitive fringe, where both types of firms doubt the probability model of demand shocks, and b) a general equilibrium economy, where a policymaker taxes linearly the labor income of a representative household in order to finance an exogenous stream of stochastic spending shocks. The policymaker can distrust the probability model of spending shocks more, the same, or less than the household. Whenever there are doubts about the model, cautious agents form endogenous worst-case beliefs by assigning high probability on low profitability or low-utility events. There are two forces that shape optimal policy results: the manipulation of the endogenous beliefs of the follower to the benefit of the leader, and the discrepancy (if any) in the pessimistic beliefs between the leader and the follower. Depending on the application, the leader may amplify or mitigate the worst-case beliefs of the follower.

JEL classification: D80, E62, H21, H63

Key words: model uncertainty, ambiguity aversion, multiplier preferences, misspecification, robustness, martingale, monopolist, competitive fringe, demand uncertainty, Ramsey taxation link

The author thanks Thomas J. Sargent for introducing him to this research agenda and providing constant encouragement and inspiration. The author is also grateful to Lars Peter Hansen and to the late David K. Backus for comments. An earlier version of this paper was titled "Doubts about the model and optimal taxation." The views expressed here are those of the author and not necessarily those of the Federal Reserve Bank of Atlanta or the Federal Reserve System. Any remaining errors are the author's responsibility.

Please address questions regarding content to Anastasios G. Karantounias, Research Department, Federal Reserve Bank of Atlanta, 1000 Peachtree St. NE, Atlanta, GA 30309,

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