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  • Pedro Garcia Duarte

The introduction of linear-quadratic methods in monetary economics in the 1960s tinged the intense debate about the optimal monetary policy instrument. These methods were widely used outside monetary economics because they delivered easy solutions to complex stochastic models. This same reason explains the success of quadratic loss functions according to the conventional wisdom among monetary economists. In this traditional narrative, Henri Theil and Herbert Simon are often cited by their proofs that models with quadratic objective functions have the certainty equivalence property. This attribute made the solution of these models feasible for the computers available at that time. This paper shows how the use of a quadratic loss function to characterize the behavior of central banks inaugurated an objective or uniform way of talking about optimality. In this respect, the discourse on optimal monetary policy stabilized. Moreover, a richer account of the quadratic approach to monetary policy debate emerges by analyzing how quadratic loss functions were used in operations research and management problems by groups of scientists that included economists like Modigliani and Simon. I argue that feasibility is only one important factor that explains the wide popularity of quadratic functions in monetary economics.

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Paper provided by ANPEC - Associação Nacional dos Centros de Pósgraduação em Economia [Brazilian Association of Graduate Programs in Economics] in its series Anais do XXXIII Encontro Nacional de Economia [Proceedings of the 33th Brazilian Economics Meeting] with number 016.

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Date of creation: 2005
Date of revision:
Handle: RePEc:anp:en2005:016
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  1. Roger N. Waud, 1975. "Asymmetric policymaker utility functions and optimal policy under uncertainty," Special Studies Papers 57, Board of Governors of the Federal Reserve System (U.S.).
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  9. Charles C. Holt & Franco Modigliani & Herbert A. Simon, 1955. "A Linear Decision Rule for Production and Employment Scheduling," Management Science, INFORMS, vol. 2(1), pages 1-30, October.
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  14. Friedman, Benjamin M, 1972. "Optimal Economic Stabilization Policy: An Extended Framework," Journal of Political Economy, University of Chicago Press, vol. 80(5), pages 1002-22, Sept.-Oct.
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  16. Sargent, Thomas J & Wallace, Neil, 1973. "Rational Expectations and the Dynamics of Hyperinflation," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 14(2), pages 328-50, June.
  17. Taylor, John B., 2001. "An Interview With Milton Friedman," Macroeconomic Dynamics, Cambridge University Press, vol. 5(01), pages 101-131, February.
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