TY - JOUR
T1 - Designing a Simple Loss Function for Central Banks
T2 - Does a Dual Mandate Make Sense?
AU - Debortoli, Davide
AU - Kim, Jinill
AU - Lindé, Jesper
AU - Nunes, Ricardo
N1 - Funding Information:
We are grateful to the editor Morten Ravn and two anonymous referees for very helpful suggestions. Jordi Galí, Marc Giannoni, Lars Svensson, Andrea Tambalotti, our discussants Tom Tallarini, Julio Andres Blanco and David Berger also provided very helpful comments. We also thank seminar and conference participants at the Bank of England, Bank of Japan, Banque de France, Banco de Portugal, Central Bank of Brazil, ECB, the Federal Reserve Banks of Atlanta, New York and Richmond, Federal Reserve Board, IMF, National Bank of Belgium, National University of Singapore, Norges Bank, Sveriges Riksbank, Universidade Nova de Lisboa, Universitat Pompeu Fabra, University London Queen Mary, University of Surrey, University of Virginia, Society of Economic Dynamics 2014, and Southern Economic Association Conference 2014 for very useful feedback. Part of the work on this article was carried out while some of the authors were employees (Lindé and Nunes) and consultant (Kim) of the International Finance Division at the Federal Reserve Board, Boston Fed (Nunes) and the IMF (Lindé). Jinill Kim acknowledges the support by Korea Research Foundation Grant funded of the Korean Government (NRF-2013S1A5A2A03044693) and Debortoli acknowledges support from the Marie Curie FP7-PEOPLE-2013-IIF grant 628855—MONFISCPOL and the Spanish Ministry of Economy and Competitiveness grant ECO2014-55555-P. The views expressed in this article are solely the responsibility of the authors and should not be interpreted as reflecting the views of Sveriges Riksbank or of any person associated with the Federal Reserve System.
PY - 2019/7/1
Y1 - 2019/7/1
N2 - 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.
AB - 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.
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U2 - 10.1111/ecoj.12630
DO - 10.1111/ecoj.12630
M3 - Article
AN - SCOPUS:85061064233
VL - 129
SP - 2010
EP - 2038
JO - Economic Journal
JF - Economic Journal
SN - 0013-0133
IS - 621
ER -