Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/152563
Authors: 
al-Nowaihi, Ali
Stracca, Livio
Year of Publication: 
2002
Series/Report no.: 
ECB Working Paper 129
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.
Subjects: 
certainty equivalence
economic psychology
monetary policy
non-quadratic loss functions
JEL: 
E52
E58
Document Type: 
Working Paper

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