1046 Alberto Alesina and Andrea Stella

becoming more and more a collection of countries with economic integration and the
sharing of certain policies among subgroups of the entire set of members. The idea of a
politically united Europe with the euro as its currency and the ECB as its central bank
is fading (see also Issing, 2008). The recent harsh divisions regarding the rescue plans
for indebted countries have highlighted different views between euro members. The
euro will have to exist without a political entity behind its back.

7. CONCLUSION
The financial crisis of 2008–2009 has shaken some of the foundations of what we
thought we knew about monetary policy and its institutions. We thought that inde-
pendent central banks targeting inflation were the solution, which would have elimi-
nated instability, political interference on monetary policy, and guaranteed an orderly
management of the macroeconomic cycle. This chapter has reviewed the literature that
has lead us to those conclusions and has begun to address what novel issues the crisis has
brought into the limelight. In this respect this chapter has raised more questions than
provided answers. It is fair to say that we have not quite digested the implications of
the crisis for the conduct of monetary policy and its institutions. Probably the next vol-
ume of Handbook of Monetary Economics in a decade or so will have all the solutions.
Now that we have clarified some of the questions we need to start looking for the
answers.

APPENDIX
1 Independent central banker
The independent central banker is chosen by minimizing the loss function with respect
^ The utility loss is
to the parameter b.
" !2
2 #
1 ^
b 1
EL ¼ E bk ^  et þ b et  k ð51Þ
2 1 þ b^ 1 þ b^
With one line of algebra we can simplify the loss function to
" #
b þ b^
2
1 2 ^2
EL ¼ k ðb þ bÞ þ s2
ð52Þ
2 ð1 þ bÞ^2 E

Minimizing the loss with respect to b^ we obtain the following first order condition:

^ ¼ bk
^2þ b^  b
3 sE ¼ 0 ð53Þ
2
FðbÞ
^
ð1 þ bÞ
 Wanting Robustness in Macroeconomics 1105

3. FORMALIZING A TASTE FOR ROBUSTNESS

The multiple prior formulations provide a way to think about model misspecification.
Like Epstein and Wang (1994) and Friedman (1959), we are specifically interested in
decision making in dynamic environments. We draw our inspiration from a line of
research in control theory. Robust control theorists challenged and reconstructed ear-
lier versions of control theory because it had ignored model-approximation error in
designing policy rules. They suspected that their models had misspecified the dynamic
responses of target variables to controls. To confront that concern, they added a speci-
fication error process to their models and sought decision rules that would work well
across a set of such error processes. That led them to a two-player zero-sum game
and a conservative-case analysis much in the spirit of Gilboa and Schmeidler (1989).
In this section, we describe the modifications of modern control theory made by the
robust control theorists. While we feature linear/quadratic Gaussian control, many of
the results that we discuss have direct extensions to more general decision environ-
ments. For instance, Hansen, Sargent, Turmuhambetova, and Williams (2006)
considered robust decision problems in Markov diffusion environments.

3.1 Control with a correct model

First, we briefly review standard control theory, which does not admit misspecified
dynamics. For pedagogical simplicity, consider the following state evolution and target
equations for a decisionmaker:
xtþ1 ¼ Axt þ But þ Cwtþ1 ð1Þ
zt ¼ Hxt þ Jut ð2Þ
where xt is a state vector, ut is a control vector, and zt is a target vector, all at date t. In
addition, suppose that {wtþ1} is a sequence of vectors of independent and identically
and normally distributed shocks with mean zero and covariance matrix given by I.
The target vector is used to define preferences via:
1X 1
 bt Ez0 t zt ð3Þ
2 t¼0

where 0 < b < 1 is a discount factor and E is the mathematical expectation operator.
The aim of the decisionmaker is to maximize this objective function by choice of con-
trol law ut ¼ Fxt. The linear form of this decision rule for ut is not a restriction but is
an implication of optimality.
The explicit, stochastic, recursive structure makes it tractable to solve the control
problem via dynamic programming: