TY - JOUR
AU - Svensson,Lars E.O.
TI - Optimal Policy with Low-Probability Extreme Events
JF - National Bureau of Economic Research Working Paper Series
VL - No. 10196
PY - 2003
Y2 - December 2003
DO - 10.3386/w10196
UR - http://www.nber.org/papers/w10196
L1 - http://www.nber.org/papers/w10196.pdf
N1 - Author contact info:
Lars E.O. Svensson
Department of Economics
Stockholm School of Economics
P.O. Box 6501
SE-11383 Stockholm
Sweden
E-Mail: lars.svensson@iies.su.se
AB - 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.
ER -