Designing a simple loss function for central banks: Does a dual mandate make sense?

Davide Debortoli, Jinill Kim, Jesper Lindé and Ricardo Nunes

Economics Working Papers from Department of Economics and Business, Universitat Pompeu Fabra

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' objectives; simple loss function; monetary policy design; sticky prices and sticky wages; DSGE models (search for similar items in EconPapers)
JEL-codes: C32 E58 E61 (search for similar items in EconPapers)
Date: 2017-03
New Economics Papers: this item is included in nep-mac
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Citations: View citations in EconPapers (4)

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Related works:
Journal Article: Designing a Simple Loss Function for Central Banks: Does a Dual Mandate Make Sense? (2019)
Working Paper: Designing a Simple Loss Function for Central Banks: Does a Dual Mandate Make Sense? (2019)
Working Paper: Designing a Simple Loss Function for Central Banks: Does a Dual Mandate Make Sense? (2017)
Working Paper: Designing a Simple Loss Function for Central Banks: Does a Dual Mandate Make Sense? (2017)
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