Stochastic Optimization and Worst-Case Analysis in Monetary Policy Design

CFS Working Paper No. 2005/14

Posted: 6 May 2005

See all articles by Berc Rustem

Berc Rustem

Imperial College London - Department of Computing; Center for Financial Studies (CFS)

Volker Wieland

University of Frankfurt

Stan Zakovic

Imperial College London - Accounting, Finance, and Macroeconomics

Multiple version iconThere are 2 versions of this paper

Date Written: March 15, 2005

Abstract

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 limiting 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.

Keywords: Worst-case analysis, robust control, minimax, monetary policy rules, euro area

JEL Classification: E52, E58, E61

Suggested Citation

Rustem, Berc and Wieland, Volker and Zakovic, Stan, Stochastic Optimization and Worst-Case Analysis in Monetary Policy Design (March 15, 2005). CFS Working Paper No. 2005/14, Available at SSRN: https://ssrn.com/abstract=716104

Berc Rustem

Imperial College London - Department of Computing ( email )

South Kensington campus
London SW7 2AZ
United Kingdom
+44 20 7594 8345/8370 (Phone)
+44 20 7581 8024 (Fax)

HOME PAGE: http://www.doc.ic.ac.uk/old-doc/berc.html

Center for Financial Studies (CFS)

Gr├╝neburgplatz 1
Frankfurt am Main, 60323
Germany

Volker Wieland (Contact Author)

University of Frankfurt ( email )

House of Finance
Gr├╝neburgplatz 1
Frankfurt am Main, D-60323
Germany
+49 69 798 33805 (Phone)
+49 69 798 33907 (Fax)

HOME PAGE: http://www.volkerwieland.com

Stan Zakovic

Imperial College London - Accounting, Finance, and Macroeconomics ( email )

South Kensington campus
London SW7 2AZ
United Kingdom

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