The Global Crisis and the European sovereign debt crisis have stimulated an intense debate about the role of central banks. Should central banks be responsible for price stability, for the stability of economic activity, or both? For example, while the ECB’s primary objective is to maintain price stability without any explicit responsibility for economic activity, the US Federal Reserve’s objective is to promote maximum sustainable employment in a context of price stability.1 Is this dual mandate beneficial for the society, or is the ECB’s inflation mandate preferable?
The literature to date, most notably the influential work by Woodford (2003), suggests that a focus on inflation stabilisation is enough to stabilise other macroeconomic variables, and that focusing on economic activity can even be harmful. In a recent paper, we challenge this view by arguing that stabilising measures of economic activity should be one of the primary objectives of central banks, as important as or even more important than stabilising inflation around its target (Debortoli et al. 2018).
Why a dual mandate rather than multiple mandates?
A central bank should in principle take into account all the economic variables affecting social welfare. Yet, no advanced country asks its central bank to do so. Instead, central banks are mandated to pursue simple objectives that involve only a few variables. Why? Because simple objectives facilitate the communication of policy actions to the public, make monetary policy more transparent, and enhance the accountability of the central bank.
But simplicity comes at a cost. Looking at only a few variables is typically inefficient, in the sense that it generates some welfare loss with respect to adopting a more complete, although complex, criterion. A natural question then arises: How can we design objectives for central banks that are simple, but that would generate the smallest possible welfare losses?
What are the most important variables? Inflation or economic activity?
Central bank objectives are typically formulated in terms of two variables: inflation and output. Such a specification captures the main challenge facing central banks. Consider for instance an economy suddenly affected by an exogenous decline in demand. If a central bank wants to stimulate economic activity, it will have to tolerate some inflation, either on prices or wages, which is costly to the society. Alternatively, if the central bank wishes to keep prices and wages constant, it would have to tolerate a decline in output. The main question is therefore how to strike a good balance between the two conflicting objectives.
What weight should be given to economic activity? Much greater than previously thought
A common result in the monetary policy literature is that stabilising measures of economic activity should receive a small weight relative to stabilising inflation. For example, the seminal work of Woodford (2003) shows that within a simple model with sticky prices, the optimal weight on output stabilization is negligible, only 4.8% of the weight on inflation. In contrast, according to a speech by Janet Yellen (2012) – who was later to become the chair of the Federal Reserve – the Federal Reserve’s dual mandate implies a weight on economic activity of about 25% of the weight on inflation, a value considerably higher than those usually considered in the academic literature.
Our work revisits these results. In contrast to previous works, we consider an economic model similar to those actually in use at central banks and policy institutions.2 The model is used as a laboratory to study the welfare implications of increasing the weight on economic activity in the central bank’s objective. A key finding is that the weight that minimises the welfare losses is higher than the values considered in the academic literature so far, regardless of the specific measures of economic activity considered (we study the output gap, output as deviation from a linear trend, and output growth). For a standard loss function with annualised inflation (deviations around target) and the output gap (actual minus potential output), our baseline specification suggests equal weights on inflation and the output gap. That is, the optimal weight on the output gap is about 20 times higher than that of Woodford (2003) and four times higher than the number in Yellen (2012).
Why a high weight on economic activity? It depends on the structure of the economy
The key driver of these results is that stabilising economic activity helps stabilising other welfare relevant variables that are not included in the central bank’s simple objective. Intuitively, the desirability of stabilising the output gap depends on the welfare costs associated with price and wage inflation. In economies with sizeable wage rigidities, stabilising economic activity is more desirable since it helps stabilising wage inflation, which generates high welfare costs. In contrast, in economies where prices are much more rigid than wages, the central bank should focus on maintaining price stability, and thus the optimal weight on economic activity should be low.
The same logic applies to other sources of inefficiencies, such as labour market frictions, monopolistic power in the goods market, and so on. Stabilising economic activity may help mitigating the costs associated to those inefficiencies.
Through a series of quantitative exercises, we show that the weight on economic activity should be high in a variety of scenarios. For instance, the result is robust to the presence of substantial measurement errors of the output gap (or potential output), to the presence of shocks that generate a trade-off between stabilising inflation and economic activity, and also when ensuring a low probability of hitting the zero lower bound on nominal interest rates.
Central banks should target economic activity when inflation expectations are anchored
All told, our key point is to argue that the academic consensus that central banks should primarily focus on price stability may not be right. As suggested by the seminal work by Kydland and Prescott (1977) and Barro and Gordon (1982), attaching a small weight on economic activity might help establish the credibility of a central bank during the inception of an inflation targeting regime. However, once such credibility has been established, our work suggests that central banks should also target measures of economic activity as well as aiming at price stabilisation whenever the economy is affected by non-trivial rigidities and inefficient shocks. In the terminology of Svensson (2010), our findings underscore the importance of ‘flexible inflation targeting’ with a prominent role for resource utilisation. This is particularly important today as fiscal constraints, in the form of stringent debt and deficit rules or elevated debt levels following the global financial crisis, may limit the scope for fiscal policy to promote economic stability going forward.
Finally, targeting economic activity also helps to address the financial cycle.3 The financial cycle and the emergence of the global financial crisis have by some commentators been advocated as a major limitation of the standard inflation targeting framework. Adding economic activity as an explicit target on par with inflation provides a central bank with a clear rationale to hike rates when the economy is running above potential even if inflation is projected to be below its target for some time.
Authors’ note: Anyviews expressed in this column are solely the responsibility of the authors and should not be interpreted as reflecting the views of Sveriges Riksbank.
Barro, R J and D B Gordon (1982), “Rules, discretion and reputation in a model of monetary policy”, Journal of Monetary Economics 12(1): 101-121.
Borio, C (2012), “The financial cycle and macroeconomics: What have we learnt?”, BIS Working Papers No 395.
Debortoli, D, J Kim, J Lindé, and R Nunes (2018), “Designing a Simple Loss Function for Central Banks: Does a Dual Mandate Make Sense?,” Economic Journal, forthcoming.
Erceg, C J, D W Henderson, and A T Levin (2000), “Optimal Monetary Policy with Staggered Wage and Price Contracts,” Journal of Monetary Economics 46: 281-313.
Kydland, F E and E C Prescott (1977), “Rules rather than discretion: The inconsistency of optimal plans,” Journal of Political Economy 85: 473-491.
Smets, Frank, and Raf Wouters (2007), “Shocks and Frictions in U.S. Business Cycles: A Bayesian DSGE Approach”, American Economic Review 97(3), 586-606.
Svensson, L E O (2010), “Inflation Targeting”, Chapter 22 in B M Friedman and M Woodford (eds), Handbook of Monetary Economics, Volume 3, Elsevier.
Yellen, J L (2012), “The Economic Outlook and Monetary Policy,” remarks at the Money Marketeers of New York University.
Woodford, M (2003), Interest and Prices, Princeton University Press.
 In January 2012, the FOMC published a statement on longer-run goals for monetary policy stating that “In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee’s assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them.” This monetary policy strategy was reaffirmed by the FOMC January 30, 2018.
 Specifically, we consider the workhorse models of Erceg et al. (2000) and Smets and Wouters (2007).
 See, for example, Borio (2012) and the references therein.