EXTREME EVENTS AND OPTIMAL MONETARY POLICY

Abstract

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.