Working Paper: NBER ID: w10196
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: monetary policy; loss functions; extreme events
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 settings (E52) | inflation (E31) |
| monetary policy settings (E52) | output gap (E23) |
| loss function (quadratic) (C29) | monetary policy response (E52) |
| loss function (quadratic-constant) (C51) | monetary policy response (E52) |
| endogenous extreme shock size (D80) | optimal policy (C61) |
| monetary policy settings (E52) | size of extreme shocks (E32) |