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

Davide Debortoli, Jinill Kim, Jesper Lindé and Ricardo Nunes

No 1601, Discussion Paper Series from Institute of Economic Research, Korea University

Abstract: Yes, it makes a lot of sense. Using the Smets and Wouters (2007) model of the U.S. economy, we find that the role of the output gap should be equal to or even more important than that of annualized inflation when designing a simple loss function to represent household welfare. The high weight on the output gap is driven by several important characteristics in the estimated model, including a low elasticity of substitution between monopolistic goods, price indexation, and sticky wages. Moreover, we document that a loss function with nominal wage inflation and the hours gap provides an even better approximation of the true welfare function than a standard objective based on inflation and the output gap. Our results hold up when we introduce interest rate smoothing in the simple mandate to capture the observed gradualism in policy behavior and to ensure that the probability of the federal funds rate hitting the zero lower bound is negligible.

Keywords: Central banks' objectives; simple loss function; monetary policy design; Smets-Wouters model (search for similar items in EconPapers)
JEL-codes: C32 E58 E61 (search for similar items in EconPapers)
Date: 2016
New Economics Papers: this item is included in nep-dge, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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Related works:
Working Paper: Designing a Simple Loss Function for the Fed: Does the Dual Mandate Make Sense? (2015)
Working Paper: Designing a simple loss function for the Fed: does the dual mandate make sense? (2015)
Working Paper: Designing a Simple Loss Function for the Fed: Does the Dual Mandate Make Sense? (2014)
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