Designing a Simple Loss Function for Central Banks: Does a Dual Mandate Make Sense?
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Summary:
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.
Series:
Working Paper No. 2017/164
Subject:
Inflation Labor Labor markets Output gap Prices Production Production growth Wages
English
Publication Date:
July 19, 2017
ISBN/ISSN:
9781484309278/1018-5941
Stock No:
WPIEA2017164
Pages:
56
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