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Stochastic Optimisation and Worst Case Analysis in Monetary Policy Design

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Author Info
S. Zakovic
V. Wieland
B. Rustem

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Abstract

In this paper, we show how stochastic optimisation and worst-case analysis can be used together in order to provide central banks with a straightforward tool for selecting a policy rule that limits worst-case outcomes while at the same time providing reasonably good performance on average. We conduct this analysis within a simple estimated model of the euro area with adaptive expectations. In particular, we consider not only uncertainty due to additive shocks but also uncertainty with respect to all the parameters of the model, including multiplicative parameters and potential nonlinearities in the inflation-output relationship. In terms of monetary policy we focus on the optimal choice of response coefficients in a Taylor-style interest rate rule that responds to inflation and the output gap and we evaluate the performance of this type of rule by means of a standard quadratic loss function in output and inflation. We then compare the rules obtained by the two different methods by comparing their respective performance in the worst-case scenario as well as the overall expected performance given the empirical probability distributions.

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Publisher Info
Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2004 with number 213.

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Date of creation: 11 Aug 2004
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Handle: RePEc:sce:scecf4:213

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Related research
Keywords: robust decisions worst case analysis expected value optimisation

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Find related papers by JEL classification:
C61 - Mathematical and Quantitative Methods - - Mathematical Methods and Programming - - - Optimization Techniques; Programming Models; Dynamic Analysis
E47 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Forecasting and Simulation

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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. 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)
  7. Andrew Levin & Volker Wieland & John C. Williams, 1998. "Robustness of simple monetary policy rules under model uncertainty," Finance and Economics Discussion Series 1998-45, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  8. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39, 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. 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)
  13. 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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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. Küster, Keith & Wieland, Volker, 2005. "Insurance Policies for Monetary Policy in the Euro Area," CEPR Discussion Papers 4956, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    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," Computing in Economics and Finance 2004 147, Society for Computational Economics. [Downloadable!]
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