Working Paper: CEPR ID: DP5019
Authors: Stan Akovi; B. Rustem; Volker Wieland
Abstract: In this paper we compare expected loss minimization to worst-case or minimax analysis in the design of simple Taylor-style rules for monetary policy using a small model estimated for the euro area by Orphanides and Wieland (2000). We find that rules optimized under a minimax objective in the presence of general parameter and shock uncertainty do not imply extreme policy activism. Such rules tend to obey the Brainard principle of cautionary policy-making in much the same way as rules derived by expected loss minimization. Rules derived by means of minimax analysis are effective insurance policies limiting maximum loss over ranges of parameter values to be set by the policy-maker. In practice, we propose to set these ranges with an eye towards the cost of such insurance cover in terms of the implied increase in expected inflation variability.
Keywords: Euro Area; Minimax; Monetary Policy Rules; Robust Control; Worst-case Analysis
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 |
|---|---|
| worst-case analysis (D79) | policy rules (E61) |
| expected loss minimization (C51) | policy rules (E61) |
| worst-case analysis (D79) | maximum loss (G33) |
| worst-case analysis (D79) | inflation variability (E31) |
| parameter uncertainty (C51) | policy response coefficients (C29) |
| type of analysis used (C38) | resulting policy rules (D78) |
| range of possible parameter values (C51) | policy response coefficients (C29) |