DP10409 Designing a Simple Loss Function for the Fed: Does the Dual Mandate Make Sense?

Author(s): Davide Debortoli, Jinill Kim, Jesper Lindé, Ricardo Nunes
Publication Date: February 2015
Keyword(s): central banks' objectives, household welfare, linear-quadratic approximation, monetary policy design, simple loss function, Smets-Wouters model
JEL(s): C32, E58, E61
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=10409

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 inflation when designing a simple loss function to represent household welfare. 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.