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Stochastic Optimization and Worst-Case Analysis in Monetary Policy Design

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Author Info
Berc Rustem () (Imperial College, London)
Volker Wieland () (University of Frankfurt)
Stan Zakovic () (Imperial College, London)

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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 policymaking in much the same way as rules derived by expected loss minimization. Rules derived by means of minimax analysis are effective insurance policies imiting 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.

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Publisher Info
Paper provided by Center for Financial Studies in its series CFS Working Paper Series with number 2005/14.

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Length: 29 pages
Date of creation: 14 Jan 2005
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Handle: RePEc:cfs:cfswop:wp200514

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Related research
Keywords: Worst-case analysis; robust control; minimax; monetary policy rules; euro area;

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Find related papers by JEL classification:
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination

References listed on IDEAS
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  1. repec:cup:macdyn:v:6:y:2002:i:1:p:111-44 is not listed on IDEAS
  2. Karakitsos, E. & Rustem, B., 1984. "Optimally derived fixed rules and indicators," Journal of Economic Dynamics and Control, Elsevier, vol. 8(1), pages 33-64, October. [Downloadable!] (restricted)
  3. Hansen, Lars Peter & Sargent, Thomas J & Tallarini, Thomas D, Jr, 1999. "Robust Permanent Income and Pricing," Review of Economic Studies, Blackwell Publishing, vol. 66(4), pages 873-907, October. [Downloadable!] (restricted)
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  4. Orphanides, Athanasios & Wieland, Volker, 2000. "Inflation zone targeting," European Economic Review, Elsevier, vol. 44(7), pages 1351-1387, June. [Downloadable!] (restricted)
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  5. Andrew Levin & Volker Wieland & John C. Williams, 2003. "The Performance of Forecast-Based Monetary Policy Rules under Model Uncertainty," CFS Working Paper Series 2003/06, Center for Financial Studies. [Downloadable!]
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  6. Andrew Levin & Volker Wieland & John C. Williams, 1998. "Robustness of Simple Monetary Policy Rules under Model Uncertainty," NBER Working Papers 6570, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  7. Rustem, Berc, 1994. "Stochastic and robust control of nonlinear economic systems," European Journal of Operational Research, Elsevier, vol. 73(2), pages 304-318, March. [Downloadable!] (restricted)
  8. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December. [Downloadable!] (restricted)
  9. Orphanides, Athanasios, 2003. "Monetary policy evaluation with noisy information," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 605-631, April. [Downloadable!] (restricted)
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  10. Svensson, Lars E. O., 1997. "Inflation forecast targeting: Implementing and monitoring inflation targets," European Economic Review, Elsevier, vol. 41(6), pages 1111-1146, June. [Downloadable!] (restricted)
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  11. Panos Parpas & Berc Rustem & Volker Wieland & Stan Zakovic, 2006. "Mean Variance Optimization of Non-Linear Systems and Worst-case Analysis," CFS Working Paper Series 2006/03, Center for Financial Studies. [Downloadable!]
  12. Giannoni, Marc P., 2002. "Does Model Uncertainty Justify Caution? Robust Optimal Monetary Policy In A Forward-Looking Model," Macroeconomic Dynamics, Cambridge University Press, vol. 6(01), pages 111-144, February. [Downloadable!]
  13. Christopher A. Sims, 2001. "Pitfalls of a Minimax Approach to Model Uncertainty," American Economic Review, American Economic Association, vol. 91(2), pages 51-54, May. [Downloadable!] (restricted)
  14. J. Tetlow, Robert & von zur Muehlen, Peter, 2001. "Robust monetary policy with misspecified models: Does model uncertainty always call for attenuated policy?," Journal of Economic Dynamics and Control, Elsevier, vol. 25(6-7), pages 911-949, June. [Downloadable!] (restricted)
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Keith Küster & Volker Wieland, 2005. "Insurance policies for monetary policy in the euro area," Working Paper Series 480, European Central Bank. [Downloadable!]
    Other versions:
  2. G. C. Lim & Paul D. McNelis, 2006. "Inflation Targeting, Learning and Q Volatility in Small Open Economies," Melbourne Institute Working Paper Series wp2006n22, Melbourne Institute of Applied Economic and Social Research, The University of Melbourne. [Downloadable!]
    Other versions:
  3. Arnulfo Rodriguez, 2004. "Robust Control: A Note on the Timing of Model Uncertainty," Computational Economics, Springer, vol. 24(3), pages 209-221, July. [Downloadable!] (restricted)
  4. Gadi Barlevy, 2009. "Policymaking under uncertainty: Gradualism and robustness," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q II, pages 38-55. [Downloadable!]
  5. Arnulfo Rodriguez, 2004. "Robust Control: A Note on the Timing of Model Uncertainty," Computing in Economics and Finance 2004 147, Society for Computational Economics. [Downloadable!]
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