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Monetary Policy Loss Functions: Two Cheers for the Quadratic

The authors examine the implications for the optimal interest rate rule that follow from relaxing the assumption that the policy-maker's loss function is quadratic. They investigate deviations from quadratics for both symmetric and asymmetric preferences for a single target and find that (i) other characterisations of risk aversion than implied by the quadratic only affect dead-weight losses, unless there is multiplicative uncertainty; and (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. The results suggest that in the context of monetary policy-making the convenient assumption of quadratic losses may not be that drastic after all.

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File URL: http://www.econ.cam.ac.uk/research/repec/cam/pdf/wp9920.pdf
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Paper provided by Faculty of Economics, University of Cambridge in its series Cambridge Working Papers in Economics with number 9920.

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Date of creation: Nov 1999
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Handle: RePEc:cam:camdae:9920
Contact details of provider: Web page: http://www.econ.cam.ac.uk/index.htm

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  1. Peter F. Christoffersen & Francis X. Diebold, 1994. "Optimal Prediction Under Asymmetric Loss," NBER Technical Working Papers 0167, National Bureau of Economic Research, Inc.
  2. Lars E O Svensson, 1996. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," Bank of England working papers 56, Bank of England.
  3. Robert J. Shiller, 1998. "Human Behavior and the Efficiency of the Financial System," NBER Working Papers 6375, National Bureau of Economic Research, Inc.
  4. repec:cup:etheor:v:13:y:1997:i:6:p:808-17 is not listed on IDEAS
  5. James Tobin, 1989. "On the Theory of Macroeconomic Policy," Cowles Foundation Discussion Papers 931, Cowles Foundation for Research in Economics, Yale University.
  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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