Designing a Simple Loss Function for the Fed: Does the Dual Mandate Make Sense?

48 Pages Posted: 10 Feb 2015

See all articles by Davide Debortoli

Davide Debortoli

Universitat Pompeu Fabra - Department of Economics and Business; Barcelona Graduate School of Economics (Barcelona GSE)

Jinill Kim

Korea University

Jesper Lindé

Sveriges Riksbank - Research Division

Ricardo Cavaco Nunes

Federal Reserve Banks - Federal Reserve Bank of Boston

Multiple version iconThere are 2 versions of this paper

Date Written: February 2015

Abstract

Yes, it makes a lot of sense. Using the Smets and Wouters (2007) model of the U.S. economy, we find that the role of the output gap should be equal to or even more important than that of inflation when designing a simple loss function to represent household welfare. Moreover, we document that a loss function with nominal wage inflation and the hours gap provides an even better approximation of the true welfare function than a standard objective based on inflation and the output gap. Our results hold up when we introduce interest rate smoothing in the simple mandate to capture the observed gradualism in policy behavior and to ensure that the probability of the federal funds rate hitting the zero lower bound is negligible.

Keywords: central banks' objectives, household welfare, linear-quadratic approximation, monetary policy design, simple loss function, Smets-Wouters model

JEL Classification: C32, E58, E61

Suggested Citation

Debortoli, Davide and Kim, Jinill and Linde, Jesper and Nunes, Ricardo Cavaco, Designing a Simple Loss Function for the Fed: Does the Dual Mandate Make Sense? (February 2015). CEPR Discussion Paper No. DP10409, Available at SSRN: https://ssrn.com/abstract=2562974

Davide Debortoli (Contact Author)

Universitat Pompeu Fabra - Department of Economics and Business ( email )

Barcelona
Spain

Barcelona Graduate School of Economics (Barcelona GSE) ( email )

Ramon Trias Fargas, 25-27
Barcelona, Barcelona 08005
Spain

Jinill Kim

Korea University ( email )

1 Anam-dong 5 ka
Seoul, 136-701

Jesper Linde

Sveriges Riksbank - Research Division ( email )

S-103 37 Stockholm
Sweden
+46 8 787 0873 (Phone)

HOME PAGE: http://www.riksbank.com

Ricardo Cavaco Nunes

Federal Reserve Banks - Federal Reserve Bank of Boston ( email )

Do you have a job opening that you would like to promote on SSRN?

Paper statistics

Downloads
1
Abstract Views
435
PlumX Metrics