This article studies the implication of extreme shocks for monetary policy. The analysis is based on a small-scale New Keynesian model with sticky prices and wages where shocks are drawn from asymmetric generalized extreme value distributions. A nonlinear perturbation solution of the model is estimated by the simulated method of moments. Under the Ramsey policy, the central bank responds nonlinearly and asymmetrically to shocks. The trade-off between targeting a gross inflation rate above 1 as insurance against extreme shocks and targeting an average gross inflation at unity to avoid adjustment costs is unambiguously decided in favor of strict price stability.
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1This article was previously circulated under the title “Extreme Events and the Fed.” The authors benefitted from comments by Luigi Boccola, Marcelle Chauvet, the editor (J. Fernández-Villaverde), and two anonymous referees. Ruge-Murcia acknowledges the support from the Social Sciences and Humanities Research Council (SSHRC), and from the Bank of Canada through its Fellowship Program. Kim’s work was supported by a grant from Korea University (K1808651). Please address correspondence to: Francisco Ruge-Murcia, Department of Economics, McGill University, 855 Sherbrooke Street West, Montreal, Quebec H3A 2T7, Canada (CA). Phone: +1 (514) 398 6063. E-mail: email@example.com.
© (2018) by the Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association
ASJC Scopus subject areas
- Economics and Econometrics