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Non-standard Central Bank loss functions; skewed risks; and certainty equivalence

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Author Info
Livio Stracca () (European Central Bank, Kaiserstrasse 29, Postfach 16 03 19, 60066 Frankfurt am Main, Germany.)
Ali Al-Nowaihi () (University of Leicester - Department of Economics, Leicester LE1 7RH, United Kingdom.)

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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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Paper provided by European Central Bank in its series Working Paper Series with number 129.

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Length: 37 pages
Date of creation: Feb 2002
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Handle: RePEc:ecb:ecbwps:20020129

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Related research
Keywords: Monetary policy; non-quadratic loss functions; economic psychologic; certainty equivalence.;

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References listed on IDEAS
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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. Cornelia Holthausen & Jean-Charles Rochet, 2002. "Efficient pricing of large value interbank payment systems," Working Paper Series 184, European Central Bank. [Downloadable!]
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  2. Alberto Locarno, 2006. "Imperfect knowledge, adaptive learning and the bias against activist monetary policies," Temi di discussione (Economic working papers) 590, Bank of Italy, Economic Research Department. [Downloadable!]
    Other versions:
  3. Carsten Detken & Alistair Dieppe & Jerome Henry & Frank Smets & Carmen Marin, 2002. "Model uncertainty and the equilibrium value of the real effective euro exchange rate," Working Paper Series 160, European Central Bank. [Downloadable!]
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