Optimal Policy with Low-Probability Extreme Events


Lars E.O. Svensson
Princeton University,

First draft: November 2002
Version 2.3: May 2004

Macroeconomics, Monetary Policy, and Financial Stability – A Festschrift in Honor of Charles (Chuck) Freedman, Proceedings of a
conference held by the Bank of Canada, Ottawa, June 2003, 79-104.


The optimal policy response to a low-probability extreme event is examined. A simple policy problem is examined with 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.

JEL Classification: E52, E58, E61

Keywords: Monetary policy, inflation targeting.