Optimal Policy with Low-Probability Extreme Events

Lars Svensson

No 4218, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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.

Keywords: Monetary policy; Inflation targeting (search for similar items in EconPapers)
JEL-codes: E52 E58 E61 (search for similar items in EconPapers)
Date: 2004-02
New Economics Papers: this item is included in nep-mac and nep-mon
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Working Paper: Optimal Policy with Low-Probability Extreme Events (2003)
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