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

Davide Debortoli, Jinill Kim, Jesper Lindé, Ricardo Nunes

Research output: Contribution to journalArticle

4 Citations (Scopus)

Abstract

Yes, a dual mandate makes a lot of sense. This article 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, stabilising economic activity also stabilises 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 stabilising inflation and resource utilisation, and also when imposing a moderate degree of interest rate volatility.

Original languageEnglish
Pages (from-to)2010-2038
Number of pages29
JournalEconomic Journal
Volume129
Issue number621
DOIs
Publication statusPublished - 2019 Jul 1

ASJC Scopus subject areas

  • Economics and Econometrics

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