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Non-standard central bank loss functions, skewed risks, and certainty equivalence

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  • al-Nowaihi, Ali
  • Stracca, Livio

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

Suggested Citation

  • al-Nowaihi, Ali & Stracca, Livio, 2002. "Non-standard central bank loss functions, skewed risks, and certainty equivalence," Working Paper Series 0129, European Central Bank.
  • Handle: RePEc:ecb:ecbwps:20020129
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    File URL: http://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp129.pdf
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    References listed on IDEAS

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    6. Bomfim, Antulio N & Rudebusch, Glenn D, 2000. "Opportunistic and Deliberate Disinflation under Imperfect Credibility," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(4), pages 707-721, November.
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    Citations

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    Cited by:

    1. Alberto Locarno, 2007. "Imperfect Knowledge, Adaptive Learning, and the Bias Against Activist Monetary Policies," International Journal of Central Banking, International Journal of Central Banking, vol. 3(3), pages 47-85, September.
    2. Livio Stracca, 2002. "Behavioural Finance and Aggregate Market Behaviour: Where do we Stand?," Discussion Papers in Economics 02/10, Department of Economics, University of Leicester.
    3. Stracca, Livio, 2004. "Behavioral finance and asset prices: Where do we stand?," Journal of Economic Psychology, Elsevier, vol. 25(3), pages 373-405, June.

    More about this item

    Keywords

    certainty equivalence; economic psychology; monetary policy; non-quadratic loss functions;

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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