rule. (Taylor 2007) sees more disadvantages than advantages in deviations
of interest rates from the movements implied by the Taylor rule. On the
other hand, (Greenspan 2004) argues that in events of the type described
above simple policy rules would be inadequate as they are unable to take into
consideration every contingency. In the same vein, (Svensson 2003) argues that
a commitment to a simple instrument rule may be far from optimal in some
circumstances. In fact, (Greenspan 2004) advocates instead a risk-management
approach, which “emphasises understanding as much as possible the many
sources of risk and uncertainty that policymakers face” (Greenspan 2004, p.
37). (Svensson and Williams 2005) develop a procedure to solve optimal
monetary policy problems under model uncertainty which, in their words,
is consistent with Greenspan’s risk-management approach. (Svensson and
Williams 2005) approach to optimal policy under model uncertainty considers
the whole probability distribution of future variables.
In this paper, we apply (Svensson and Williams 2005) solution methods to
a DSGE model with investment and uncertainty concerning the nature of asset
price movements. In (Dupor 2005) model, agents cannot distinguish between
fundamental and non-fundamental shocks in asset prices. In this paper, we
add an additional source of uncertainty to Dupor’s setting. The additional
uncertainty affects the behaviour of asset prices via a Markov-switching autoregressive
coefficient in both fundamental and non-fundamental shocks. The assumption
of Markov-switching non-fundamental shocks adds realism to the model, judging
by the empirical evidence reported in, among others, (Cecchetti, Lam, and
Mark 1990), (Bonomo and Garcia 1994) and (Driffill and Sola 1998).
We use this setting, where fads and bubbles in asset prices are modelled
as non-linear processes, to compare the performance of Taylor-type rules with
the optimal policy in stabilising the economy. In the Taylor-type rules that
we consider in this paper, the interest rate reacts with fixed coefficients to a