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Monetary policy loss functions: two cheers for the quadratic

  • CHADHA, Jagjit
  • SCHELLEKENS, Philip

Following Blinder’s (1997) suggestion, we examine the implications for the optimal interest rate rule which follow from relaxing the assumption that the policymaker’s loss function is quadratic. We investigate deviations from quadratics for both symmetric and asymmetric preferences for a single target and find that (i) other characterizations of risk aversion than implied by the quadratic only affect dead-weight losses, unless there is multiplicative uncertainty; (ii) asymmetries affect the optimal rule under both additive and multiplicative uncertainty but result in interest rate paths observationally similar, and in some cases equivalent, to those implied by a shifted quadratic; (iii) the use of asymmetric loss functions leads to important insights on the issue of goal independence and monetary policy delegation; (iv) non-quadratic preferences, per se, are neither sufficient nor necessary to generate the ‘Brainard conservatism principle’ and thus do not offer much added value when analyzing policy issues of caution and gradualism. Our results suggest that in the context of monetary policymaking the convenient assumption of quadratic losses may not be that drastic after all.

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Paper provided by University of Antwerp, Faculty of Applied Economics in its series Working Papers with number 1999002.

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Length: 41 pages
Date of creation:
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Handle: RePEc:ant:wpaper:1999002
Contact details of provider: Postal: Prinsstraat 13, B-2000 Antwerpen
Web page: https://www.uantwerp.be/en/faculties/applied-economic-sciences/

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  1. Peter F. Christoffersen & Francis X. Diebold, . "Optimal Prediction Under Asymmetric Loss," CARESS Working Papres 97-20, University of Pennsylvania Center for Analytic Research and Economics in the Social Sciences.
  2. Svensson, Lars E O, 1996. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," CEPR Discussion Papers 1511, C.E.P.R. Discussion Papers.
  3. James Tobin, 1989. "On the Theory of Macroeconomic Policy," Cowles Foundation Discussion Papers 931, Cowles Foundation for Research in Economics, Yale University.
  4. Shiller, Robert J., 1999. "Human behavior and the efficiency of the financial system," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 20, pages 1305-1340 Elsevier.
  5. repec:cup:etheor:v:13:y:1997:i:6:p:808-17 is not listed on IDEAS
  6. Deaton, Angus, 1992. "Understanding Consumption," OUP Catalogue, Oxford University Press, number 9780198288244, March.
  7. Horowitz, Ann R., 1987. "Loss functions and public policy," Journal of Macroeconomics, Elsevier, vol. 9(4), pages 489-504.
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