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Optimal Policy with Low-Probability Extreme Events

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  • Lars E.O. Svensson

Abstract

The optimal policy response to a low-probability extreme event is examined. A simple policy problem is solved for a sequence of different loss functions: quadratic, combined quadratic/absolute-deviation, absolute-deviation, combined quadratic/constant, and perfectionist. The paper shows that, under some simplifying assumptions, each of these loss functions puts less weight on a low-probability extreme event than the previous one, down to the quadratic/constant and perfectionist loss functions, which completely ignores the low-probability extreme event. The case when the size of the extreme shock is endogenous and depends on the policy is also examined. This introduces an additional effect on the optimal policy except for the combined quadratic/constant and the perfectionist loss functions.

Suggested Citation

  • Lars E.O. Svensson, 2003. "Optimal Policy with Low-Probability Extreme Events," NBER Working Papers 10196, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:10196
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    References listed on IDEAS

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    1. Svensson, Lars E O, 1999. "Price Stability as a Target for Monetary Policy: Defining and Maintaining Price Stability," CEPR Discussion Papers 2196, C.E.P.R. Discussion Papers.
    2. Charles Goodhart & Margaret Bray, 2002. "You Might as Well be Hung for a Sheep as a Lamb: The Loss Function of an Agent," FMG Discussion Papers dp418, Financial Markets Group.
    3. Lars E. O. Svensson, 2003. "What Is Wrong with Taylor Rules? Using Judgment in Monetary Policy through Targeting Rules," Journal of Economic Literature, American Economic Association, vol. 41(2), pages 426-477, June.
    4. Lars E.O. Svensson, 2003. "Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others," Journal of Economic Perspectives, American Economic Association, vol. 17(4), pages 145-166, Fall.
    5. Lars E. O. Svensson, 2002. "Monetary policy and real stabilization," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 261-312.
    6. repec:sae:niesru:v:167:y::i:1:p:106-112 is not listed on IDEAS
    7. Bray, Margaret & Goodhart, Charles, 2002. "You might as well be hung for a sheep as a lamb: the loss function of an agent," LSE Research Online Documents on Economics 24937, London School of Economics and Political Science, LSE Library.
    8. repec:pri:cepsud:83svensson is not listed on IDEAS
    9. John B. Taylor & Chair, 2002. "General discussion : monetary policy and real stabilization," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 319-331.
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    Citations

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    Cited by:

    1. Jinill KIM & Francisco RUGE-MURCIA, 2016. "Extreme Events and Optimal Monetary Policy," Cahiers de recherche 09-2016, Centre interuniversitaire de recherche en ├ęconomie quantitative, CIREQ.
    2. Disyatat, Piti, 2010. "Inflation targeting, asset prices, and financial imbalances: Contextualizing the debate," Journal of Financial Stability, Elsevier, vol. 6(3), pages 145-155, September.
    3. Katerina Smidkova, 2003. "Methods Available to Monetary Policy Makers to Deal with Uncertainty," Macroeconomics 0310002, EconWPA.
    4. Waters, George A., 2007. "Regime changes, learning and monetary policy," Journal of Macroeconomics, Elsevier, vol. 29(2), pages 255-282, June.

    More about this item

    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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