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

44 Pages Posted: 19 Oct 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: 2015-03-10

Abstract

Variable and high rates of price inflation in the 1970s and 1980s led many countries to delegate the conduct of monetary policy to "instrument-independent" central banks and to give their central banks a clear mandate to pursue price stability and instrument independence to achieve it. Advances in academic research supported a strong focus on price stability as a means to enhance the independence and credibility of monetary policymakers. An overwhelming majority of these central banks also adopted an explicit inflation target to further strengthen credibility and facilitate accountability. One exception is the U.S. Federal Reserve, which since 1977 has been assigned the so-called "dual mandate," which requires it to "promote maximum employment in a context of price stability." Although the Fed has established credibility for the long-run inflation target, an important question is whether its heavy focus on resource utilization can be justified. The authors' reading of the academic literature is that resource utilization should be assigned a small weight relative to inflation under the reasonable assumption that the underlying objective of monetary policy is to maximize the welfare of households inhabiting the economy. Woodford (1998) showed that the objective function of households in a basic New Keynesian sticky-price model could be approximated as a (purely) quadratic function in inflation and the output gap, with the weights determined by the specific features of the economy. A potential drawback with the large literature that followed is that it focused on relatively simple calibrated (or partially estimated) models. In this paper the authors revisit this issue within the context of an estimated medium-scale model of the U.S. economy, specifically the Smets and Wouters (2007) model.

Keywords: central banks, objectives, simple loss function, monetary policy design, 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? (2015-03-10). FRB of Boston Working Paper No. 15-3, Available at SSRN: https://ssrn.com/abstract=2675696

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 )

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