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Non-standard central bank loss functions, skewed risks, and certainty equivalence

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  • al-Nowaihi, Ali
  • Stracca, Livio

Abstract

This paper sets out to investigate the role of additive uncertainty under plausible non-standard central bank loss functions over future inflation. Building on a substantial body of evidence in the economic psychology literature, this paper postulates (i) period-by-period loss functions that are non-convex, I.e. displaying diminishing or non-increasing sensitivity to losses, and (ii) non-linear weighing of probabilities, hence departing from the expected utility paradigm. The main conclusion of the study is that if the additive uncertainty is caused by a non-normal distributed additive shock, for instance if the probability distribution of the shock is skewed, then with these departures from the quadratic function the principle of certainty equivalence does not hold anymore. Thus, it appears that with additive uncertainty of the non-normal type the assumption of a quadratic loss function for the central banker may not be as innocuous as it is commonly regarded. JEL Classification: E52, E58

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Bibliographic Info

Paper provided by European Central Bank in its series Working Paper Series with number 0129.

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Date of creation: Feb 2002
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Handle: RePEc:ecb:ecbwps:20020129

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Related research

Keywords: certainty equivalence; economic psychology; monetary policy; non-quadratic loss functions;

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  1. Clark, Peter & Laxton, Douglas & Rose, David, 2001. "An Evaluation of Alternative Monetary Policy Rules in a Model with Capacity Constraints," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(1), pages 42-64, February.
  2. RUGE-MURCIA, Francisco .J., 2001. "Inflation Targeting Under Asymmetric Preferences," Cahiers de recherche 2001-04, Universite de Montreal, Departement de sciences economiques.
  3. Lars E.O. Svensson & Michael Woodford, 2000. "Indicator variables for optimal policy," Proceedings, Federal Reserve Bank of San Francisco.
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  8. Glenn D. Rudebusch, 1999. "Is the Fed too timid? Monetary policy in an uncertain world," Working Papers in Applied Economic Theory 99-05, Federal Reserve Bank of San Francisco.
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  17. Pearlman, Joseph G., 1992. "Reputational and nonreputational policies under partial information," Journal of Economic Dynamics and Control, Elsevier, vol. 16(2), pages 339-357, April.
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Cited by:
  1. Alberto Locarno, 2007. "Imperfect Knowledge, Adaptive Learning, and the Bias Against Activist Monetary Policies," International Journal of Central Banking, International Journal of Central Banking, vol. 3(3), pages 47-85, September.
  2. Livio Stracca, 2002. "Behavioural Finance and Aggregate Market Behaviour: Where do we Stand?," Discussion Papers in Economics 02/10, Department of Economics, University of Leicester.
  3. Stracca, Livio, 2004. "Behavioral finance and asset prices: Where do we stand?," Journal of Economic Psychology, Elsevier, vol. 25(3), pages 373-405, June.

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