Working Paper: CEPR ID: DP4218
Authors: Lars E. O. Svensson
Abstract: The optimal policy response to a low-probability extreme event is examined. A simple policy problem is solved for a sequence of different loss functions: quadratic, combined quadratic/absolute-deviation, absolute-deviation, combined quadratic/constant, and perfectionist. The Paper shows that, under some simplifying assumptions, each of these loss functions puts less weight on a low-probability extreme event than the previous one, down to the quadratic/constant and perfectionist loss functions, which completely ignores the low-probability extreme event. The case when the size of the extreme shock is endogenous and depends on the policy is also examined. This introduces an additional effect on the optimal policy except for the combined quadratic/constant and the perfectionist loss functions.
Keywords: inflation targeting; monetary policy
JEL Codes: E52; E58; E61
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| monetary policy under standard quadratic loss functions (C54) | account for the mean size of extreme shocks (C46) |
| quadratic loss function (C46) | normal mean inflation should be set to achieve the inflation target (E31) |
| perfectionist loss function (D41) | focus on mode inflation, disregarding low-probability extreme events (E32) |
| endogeneity of extreme shock size to policy (E65) | alters the optimal policy response (E61) |
| normal mean inflation may undershoot the inflation target by less than the mean size of extreme shock (E31) | when the policy instrument is adjusted (E61) |
| marginal loss associated with deviations from targets (L21) | guides optimal policy adjustments (E61) |