Lane (2004) examines the effect of policy uncertainty in the European Union, he finds that multiplicative or model uncertainty is a relevant feature of the European policymaking process. Model uncertainty affects policy-makers’ interactions, especially those between fiscal and monetary authorities. Lane (2004) suggests that incorporating multiplicative uncertainty into monetary and fiscal policy formulations is an important modeling priority. Model uncertainty is empirically relevant also for the United States; for instance, by exploiting archives of the model code, coefficients, baseline databases and stochastic shock sets stored after each FOMC meeting between 1996 and 2003, Ironside and Tetlow (2007) document how uncertainty is a substantial problem of the Fed policymaking process. More in general, Taylor (1999) argues that the developments of information technology increase uncertainty about the policymaking process and thus it should increase the interests of economist in studying and modeling its effects.
In a pioneering study, Brainard (1967) shows that multiplicative uncertainty makes the policy-maker more prudent, i.e. under model uncertainty the policy-maker reacts less to disturbances than in the case of certainty. More recently, Peersman and Smets (1999) and Soderstrom (2002) have extended the Brainard’s argument to monetary policy in the European Monetary Union context. In the spirit of Lane’s (2004) observations, a number of authors have attempted to model and evaluate multiplicative uncertainty by considering its effects on optimal monetary policy; in a similar manner, other researchers have focused on the effects of different kind of uncertainty in the conduct of fiscal policy. However, despite the increasing number of studies, the importance of uncertainty in the interaction between fiscal and monetary policies has been neglected; hence, the Lane’s (2004) observations have been only partially considered. Our aim is to fill this gap.
Acknowledging the relevance of uncertainty on the effects of policymakers’ choices, we evaluate the consequences which are produced on the effects of fiscal policy by the introduction of multiplicative uncertainty in a class of policy games recently developed by Dixit and Lambertini (D&L from now onwards). D&L’s models have are particular attractive for our investigation since they consider the interaction between fiscal and monetary stabilization policies in a rather general manner since they consider different assumptions about the transmission mechanisms of the policies. In addition, model uncertainty can be easily introduced in this class of models since D&L observe that additive uncertainty is a very restrictive case and, thus, assume that the private sector is subjected to multiplicative uncertainty.
One of the main findings of D&L is related to the effects of the symbiosis assumption. Symbiosis means that fiscal and monetary authorities share identical (ideal or desired) output and inflation targets, but not necessary equal marginal rate of substitutions between these objectives in their preference functions. D&L (2003b) find that symbiosis implies that ideal output and inflation will be always achieved; otherwise policymakers’ non-cooperative interactions always lead to inefficient equilibria (see D&L, 2001). Although this result is obtained in a monetary union, it holds also in a single country. Thus, for the sake of brevity, we will only consider the case of one country, but our results can be easily extended to a monetary union. We leave this task to further researches.
Our paper studies the effects of multiplicative uncertainty on the stabilization policy under the symbiosis assumption. We show that uncertainty may be no longer neutral (for average outcomes) and may imply different results. In particular, the symbiosis assumption does no longer guarantee the achievement of ideal targets unless the policymakers’ ideal output is equal to its natural level, i.e. no cheating incentive. Differently from the perfect information case, a time consistency problem arises, which also implies that monetary and fiscal authorities have to be more conservative than the society in order to minimize a generic social welfare loss.