This paper uses a model in which prices and wages adjust slowly to economic fluctuations to assess the optimal degree of monetary policy tightening under uncertainty about the magnitude of a shock that causes both an increase in inflation and a decrease in output (stagflation). The optimal tightening of monetary policy is compared with the one that would occur in the absence of uncertainty about the magnitude of the shock.
Under uncertainty, the central bank should act with caution and raise the monetary policy rate more moderately than would be optimal if the size of the stagflationary shock were known. Greater caution would be required if excessive increases in the monetary policy rate were to create tensions in financial markets.
