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Stochastic optimization and worst-case analysis in monetary policy design

  • Rustem, Berc
  • Wieland, Volker
  • Zakovic, Stan

In this paper we compare expected loss minimization to worst-case or minimax analysis in the design of simple Taylor-style rules for monetary policy using a small model estimated for the euro area by Orphanides and Wieland (2000). We find that rules optimized under a minimax objective in the presence of general parameter and shock uncertainty do not imply extreme policy activism. Such rules tend to obey the Brainard principle of cautionary policymaking in much the same way as rules derived by expected loss minimization. Rules derived by means of minimax analysis are effective insurance policies imiting maximum loss over ranges of parameter values to be set by the policy maker. In practice, we propose to set these ranges with an eye towards the cost of such insurance cover in terms of the implied increase in expected inflation variability.

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Paper provided by Center for Financial Studies (CFS) in its series CFS Working Paper Series with number 2005/14.

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Date of creation: 2005
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Handle: RePEc:zbw:cfswop:200514
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  1. Andrew Levin & Volker Wieland & John C. Williams, 1998. "Robustness of simple monetary policy rules under model uncertainty," Finance and Economics Discussion Series 1998-45, Board of Governors of the Federal Reserve System (U.S.).
  2. Onatski, Alexei & Stock, James H., 2002. "Robust Monetary Policy Under Model Uncertainty In A Small Model Of The U.S. Economy," Macroeconomic Dynamics, Cambridge University Press, vol. 6(01), pages 85-110, February.
  3. Peter Isard & Douglas Laxton & Ann-Charlotte Eliasson, 1999. "Simple Monetary Policy Rules Under Model Uncertainty," International Tax and Public Finance, Springer, vol. 6(4), pages 537-577, November.
  4. Lars Hansen & Thomas Sargent & Thomas Tallarini, . "Robust Permanent Income and Pricing," GSIA Working Papers 1997-51, Carnegie Mellon University, Tepper School of Business.
  5. Andrew Levin & John C. Williams, 2000. "The Performance of Forecast-Based Monetary Policy Rules under Model Uncertainty," Econometric Society World Congress 2000 Contributed Papers 1781, Econometric Society.
  6. Svensson, Lars E O, 1996. "Inflation Forecast Targeting: Implementing and Monitoring Inflation Targets," CEPR Discussion Papers 1511, C.E.P.R. Discussion Papers.
  7. Orphanides, Athanasios, 2003. "Monetary policy evaluation with noisy information," Journal of Monetary Economics, Elsevier, vol. 50(3), pages 605-631, April.
  8. Laurence Ball, 1998. "Policy Rules for Open Economies," NBER Working Papers 6760, National Bureau of Economic Research, Inc.
  9. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  10. Christopher A. Sims, 2001. "Pitfalls of a Minimax Approach to Model Uncertainty," American Economic Review, American Economic Association, vol. 91(2), pages 51-54, May.
  11. Peter von zur Muehlen, 2001. "Activist vs. non-activist monetary policy: optimal rules under extreme uncertainty," Finance and Economics Discussion Series 2001-02, Board of Governors of the Federal Reserve System (U.S.).
  12. Robert J. Tetlow & Peter von zur Muehlen, 2000. "Robust monetary policy with misspecified models: does model uncertainty always call for attenuated policy?," Finance and Economics Discussion Series 2000-28, Board of Governors of the Federal Reserve System (U.S.).
  13. Orphanides, Athanasios & Wieland, Volker, 2000. "Inflation zone targeting," European Economic Review, Elsevier, vol. 44(7), pages 1351-1387, June.
  14. Karakitsos, E. & Rustem, B., 1984. "Optimally derived fixed rules and indicators," Journal of Economic Dynamics and Control, Elsevier, vol. 8(1), pages 33-64, October.
  15. Giannoni, Marc P., 2002. "Does Model Uncertainty Justify Caution? Robust Optimal Monetary Policy In A Forward-Looking Model," Macroeconomic Dynamics, Cambridge University Press, vol. 6(01), pages 111-144, February.
  16. repec:cup:macdyn:v:6:y:2002:i:1:p:111-44 is not listed on IDEAS
  17. Rustem, Berc, 1994. "Stochastic and robust control of nonlinear economic systems," European Journal of Operational Research, Elsevier, vol. 73(2), pages 304-318, March.
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