Designing Central Bank Loss Functions

Yuan, Huiping; Miller, Stephen M.

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Designing Central Bank Loss Functions

International Journal of Business and Economics, Aprill 2010

5 Pages Posted: 11 Aug 2007 Last revised: 26 Dec 2010

See all articles by Huiping Yuan

Stephen M. Miller

University of Nevada, Las Vegas - Department of Economics; University of Connecticut - Department of Economics

Date Written: February 15, 2010

Abstract

Kydland and Prescott (1977) show that optimal policy proves inconsistent because of rational expectations. This paper shows that the inconsistency of optimal policy comes from the inconsistency of the social loss function with the economic structure. As a result, we delegate to the central bank a different loss function, which is consistent with the economic structure. Under the delegated loss function, consistent policy proves optimal for the social welfare. We interpret the delegated central bank loss function as an intermediate objective (an institutional mechanism) and the social loss function as the ultimate objective. The ultimate objective is optimized through the institutional mechanism.

Keywords: optimal policy, consistent policy, time inconsistency

JEL Classification: E42, E52, E58

Suggested Citation: Suggested Citation

Yuan, Huiping and Miller, Stephen M., Designing Central Bank Loss Functions (February 15, 2010). International Journal of Business and Economics, Aprill 2010, Available at SSRN: https://ssrn.com/abstract=1006304