| Publications [#32755] of Pedro G. Duarte
Working Papers
- Pedro G. Duarte, A Feasible and Objective Concept of Optimality: the quadratic loss function and U.S. monetary policy in the 1960s and the 1970s
(Fall, 2006)
(last updated on 2006/11/16)
Abstract: The introduction of linear-quadratic
methods in monetary economics in the 1960s
tinged the intense debate about the optimal
monetary policy instrument. These methods
were widely used outside monetary economics
because they delivered easy solutions to
complex stochastic models. This same reason
explains the success of quadratic loss
functions according to the conventional
wisdom among monetary economists. In this
traditional narrative, Henri Theil and
Herbert Simon are often cited by their proofs
that models with quadratic objective
functions have the certainty equivalence
property. This attribute made the solution of
these models feasible for the computers
available at that time. This paper shows how
the use of a quadratic loss function to
characterize the behavior of central banks
inaugurated an objective or uniform way of
talking about optimality. In this respect,
the discourse on optimal monetary policy
stabilized. Moreover, a richer account of the
quadratic approach to monetary policy debate
emerges by analyzing how quadratic loss
functions were used in operations research
and management problems, by groups of
scientists that included economists like
Modigliani and Simon. I argue that
feasibility is only one important factor,
among others explored in the paper,
explaining the wide popularity of quadratic
functions in monetary economics.
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