Designing a Simple Loss Function for Central Banks: Does a Dual Mandate Make Sense?
57 Pages Posted: 1 Feb 2018
Date Written: July 2017
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: Suggested Citation