Behavioural Central Bank Loss Functions, Skewed Risks and Certainty Equivalence

Abstract

We set out to investigate the role of additive uncertainty under behaviourally plausible non‐standard central bank loss functions on future inflation. Building on a substantial body of evidence in the economic psychology literature, we propose (i) period‐by‐period loss functions that are non‐convex, i.e. displaying diminishing or non‐increasing sensitivity to losses, and (ii) non‐linear weighting of probabilities, hence departing from the expected utility paradigm. The main conclusion of the study is that if the additive uncertainty is caused by a non‐normal distributed additive shock, for instance if the probability distribution of the shock is skewed, then with these departures from the quadratic function the principle of certainty equivalence does not hold anymore.