The Asymmetric Loss Function and the Central Banks’ Ability in Developing Countries

Abstract

This paper seeks to develop a theoretical strand of research in monetary economics by modelling central bank ability in the loss function. Recently, many working papers issued by the International Monetary Fund (IMF) prove that some central banks, particularly from developing countries, are suffering from serious operational problems that might affect their abilities to control the economy. Simultaneously, a literature review shows that the movements are toward using asymmetric loss function. Therefore, we utilize this function in the standard monetary approach. The results proved that both central bank ability and preference in developing countries are fundamental to explain inflation bias and the movement of monetary policy instrument.

Keywords:

• Asymmetric loss function
• central bank ability
• central bank losses
• inflation rate
• developing countries

Notes

1. For more details see al-Nowaihi and Stracca (2002).

2. This upgrade is consistent with the definition of central bank ability in this study.

3. Svensson (2003, pp. 11–25) described how to achieve the optimal compromise between inflation stability and output gap stability.

4. For more details see Nagar (2007) and Goodhart (2001).

5. For more details about the debate of monetary policy inertia, see Gerlach-Kirsten (2004) and Rudebusch (2006).

6. The shocks have a skewed probability distribution.

7. These central banks are Sveriges Riksbank, Bank of England, and European Central Bank.

8. Leone (1993) presented data from 14 countries.

9. For more details about remedies see Dalton and Dziobek (2005), Stella (1997), and Leone (1993).

10. We assume that either the central bank has the power to affect the economy or not. Thus, the values of the ability is either A= + 1 or A= − l.

11. Recall, the goal of the central bank in this study is not to minimize the aggregate demand and aggregate supply shocks. As a result, we expect to find no connection between these shocks and central bank ability.

12. The slope of the aggregate supply function is .

13. (X ²) versus (−X ²).

14. For more details see Christoffersen and Diebold (1997), Chadha and Schellekens (1999), and Knight (2000).

15. Also, Nagar (2007) used this technique.

16. Compare this term with the second term of Equation (8).

17. This is consistent with the definition of central bank abihty of this study. We will expand this definition in a further study.

18. This assumption does not affect the conclusions.

19. This is consistent with the definition of multiplicative uncertainty which is introduced earlier.

20. Recall, in this case we assumed that the central bank preferences is just over inflation rate only.