Designing a Simple Loss Function for Central Banks: Does a Dual Mandate Make Sense?

57 Pages Posted: 1 Feb 2018

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

Ricardo Cavaco Nunes

Federal Reserve Banks - Federal Reserve Bank of Boston

Date Written: July 2017

Abstract

Yes, it makes a lot of sense. This paper studies how to design simple loss functions for central banks, as parsimonious approximations to social welfare. We show, both analytically and quantitatively, that simple loss functions should feature a high weight on measures of economic activity, sometimes even larger than the weight on inflation. Two main factors drive our result. First, stabilizing economic activity also stabilizes other welfare relevant variables. Second, the estimated model features mitigated inflation distortions due to a low elasticity of substitution between monopolistic goods and a low interest rate sensitivity of demand. The result holds up in the presence of measurement errors, with large shocks that generate a trade-off between stabilizing inflation and resource utilization, and also when ensuring a low probability of hitting the zero lower bound on interest rates.

Keywords: Central banks, Monetary policy, Sticky prices, Sticky wages, Econometric models, Central banks objectives, simple loss function, monetary policy design, sticky prices and sticky wages, DSGE models, Central banks; objectives, Time-Series Models

JEL Classification: C32, E58, E61

Suggested Citation

Debortoli, Davide and Kim, Jinill and Lindé, Jesper and Nunes, Ricardo Cavaco, Designing a Simple Loss Function for Central Banks: Does a Dual Mandate Make Sense? (July 2017). IMF Working Paper No. 17/164, Available at SSRN: https://ssrn.com/abstract=3116196

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 Lindé

Sveriges Riksbank

Brunkebergstorg 11
SE-103 37 Stockholm
Sweden

Ricardo Cavaco Nunes

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

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