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. To this end we use 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 also tend to obey the Brainard principle, which implies that policy responsiveness declines with increasing uncertainty about policy effectiveness. We find that 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.
This is a preview of subscription content, access via your institution.
Buy single article
Instant access to the full article PDF.
Price excludes VAT (USA)
Tax calculation will be finalised during checkout.
Ball, L. (1999). Policy rules for open economies, in, Taylor, J.B. (ed.). Monetary policy rules, NBER and University of Chicago Press, Chicago.
Basar, T. and Bernhard, P. (1991). H∞ – Optimal control and related minimax design problems, Birkhauser, Boston.
Brainard, W. (1967). Uncertainty and the Effectiveness of Policy. American Economic Review, 57, 411–25.
Giannoni, M. (2002). Does model uncertainty justify caution? Robust optimal monetary policy in a forward-looking model. Macroeconomic Dynamics, 6(1), 111–144.
Hansen, L. and T. Sargent (forthcoming), Misspecification in recursive macro-economic theory. Manuscript.
Hansen, L., Sargent, T.J., and Tallarini, T.D. (1999). Robust permanent income and pricing. Review of Economic Studies, 66, 873–907.
Karakitsos, E. and Rustem B. (1984). Optimally derived fixed rules and indicators. Journal of Economic Dynamics and Control, 8, 33–64.
Levin, A., Williams, J.C. and Wieland, V. (1999). Robustness of simple monetary policy rules under model uncertainty, in John B. Taylor (ed.). Monetary Policy Rules, NBER and Chicago Press, June 1999.
Levin, A., Williams, J.C. and Wieland, V. (2003). The performance of forecast-based monetary policy rules under model uncertainty. American Economic Review, 93(3), June.
Onatski, A. and Stock, J. (2002). Robust monetary policy under uncertainty in a small model of the macroeconomy. Macroeconomic Dynamics, 6(1).
Orphanides, A. (2003). Monetary policy evaluation with noisy information. Journal of Monetary Economics, 50(3), 605–631.
Orphanides, A., and Wieland, V. (2000). Inflation zone targeting. European Economic Review, 44, 1351–1387.
Rustem, B. (1994). Stochastic and robust control of nonlinear economic systems. European Journal of Operational Research, 304–318.
Rustem, B., and Howe, M.A. (2002). Algorithms for worst-case design with applications to risk management, Princeton University Press.
Rustem, B. and Zakovic, S. (2004). An interior point algorithm for continuous minimax problems, working paper, Imperial College.
Sargent, T. (1999). Discussion of policy rules for open economies in, Taylor, J.B. (ed.). Monetary policy rules, NBER and University of Chicago Press, Chicago.
Sims, C.A. (2001). Pitfalls of a minimax approach to model uncertainty. American Economic Review, 91(2), 51–54.
Svensson, L. (1997). Inflation forecast targeting: Implementing and monitoring inflation targets. European Economic Review, 41, 1111–1146.
Svensson, L. (2000). Robust control made simple. working paper, Princeton University.
Taylor, J.B. (1993). Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy, 39, 195–214.
Tetlow, R. and Muehlen, P. von zur (2001). Robust monetary policy with misspecified models: Does model uncertainty always call for attenuated policy?. Journal of Economic Dynamics and Control, 25, 911–949.
Muehlen, von zur P. (1982). Activist versus non-activist monetary policy: Optimal policy rules under extreme uncertainty, Manuscript, Federal Reserve Board, Washington, DC, April 1982.
Zakovic, S., Rustem, B., and Wieland, V. (2004). Mean variance optimization of non–linear systems and worst-case analysis, working paper.
Zakovic, S., Rustem, B., and Wieland, V. (2002), A continuous minimax problem and its application to inflation targeting in G. Zaccour, ed. Decision and control in management science, Kluwer Academic Publishers, 2002.
JEL Classifications System: E52, E58, E61
About this article
Cite this article
Žaković, S., Wieland, V. & Rustem, B. Stochastic Optimization and Worst-Case Analysis in Monetary Policy Design. Comput Econ 30, 329–347 (2007). https://doi.org/10.1007/s10614-005-9012-4