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

By Davide Debortoli, Jinill Kim, Jesper Lindé, Ricardo C Nunes

July 19, 2017

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Format: Chicago

Davide Debortoli, Jinill Kim, Jesper Lindé, and Ricardo C Nunes. Designing a Simple Loss Function for Central Banks: Does a Dual Mandate Make Sense?, (USA: International Monetary Fund, 2017) accessed November 24, 2024

Disclaimer: IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.

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.

Subject: Inflation, Labor, Labor markets, Output gap, Prices, Production, Production growth, Wages

Keywords: Central bank, Central banks’ objectives, DSGE models, Europe, Inflation, Inflation-output gap mandate, Inflation-output gap trade-off, Labor markets, Loss function, Monetary policy design, Output gap, Output gap fluctuation, Production growth, Simple loss function, Sticky prices and sticky wages, Wage inflation, Wages, WP

Publication Details

Pages:

56
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2017/164
Stock No:

WPIEA2017164
ISBN:

9781484309278
ISSN:

1018-5941

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