A prudent central banker

This paper studies the role of prudence in modern central banking. To that end, it relaxes the usual assumption of quadratic preferences and adopts instead an asymmetric preference specification whereby positive deviations from a target can be weighted more, or less, severely than negative deviations. It is shown that prudence with respect to inflation (unemployment) reduces (increases) equilibrium inflation. The overall effect depends on the relative magnitude of the preference parameters and the conditional variances of inflation and unemployment. The implications of the model are examined using cross-section data from OECD countries. [JEL E58, E61] This paper studies the role of prudence in modern central banking. To that end, it relaxes the usual assumption of quadratic preferences and adopts instead a specification that is asymmetric around the inflation and unemployment targets. In particular, positive deviations from the target can be weighted more or less severely than negative deviations. Under quadratic preferences, the loss associated with a deviation depends only on its magnitude. In contrast, under asymmetric preferences both the magnitude and sign of a deviation matter to the central banker. This more general preference specification has nontrivial implications for monetary policy and modifies some of the previous conclusions derived under th