Working Paper

Designing a simple loss function for the Fed: does the dual mandate make sense?

Abstract: Variable and high rates of price inflation in the 1970s and 1980s led many countries to delegate the conduct of monetary policy to \"instrument-independent\" central banks and to give their central banks a clear mandate to pursue price stability and instrument independence to achieve it. Advances in academic research supported a strong focus on price stability as a means to enhance the independence and credibility of monetary policymakers. An overwhelming majority of these central banks also adopted an explicit inflation target to further strengthen credibility and facilitate accountability. One exception is the U.S. Federal Reserve, which since 1977 has been assigned the so-called \"dual mandate,\" which requires it to \"promote maximum employment in a context of price stability.\" Although the Fed has established credibility for the long-run inflation target, an important question is whether its heavy focus on resource utilization can be justified. The authors' reading of the academic literature is that resource utilization should be assigned a small weight relative to inflation under the reasonable assumption that the underlying objective of monetary policy is to maximize the welfare of households inhabiting the economy. Woodford (1998) showed that the objective function of households in a basic New Keynesian sticky-price model could be approximated as a (purely) quadratic function in inflation and the output gap, with the weights determined by the specific features of the economy. A potential drawback with the large literature that followed is that it focused on relatively simple calibrated (or partially estimated) models. In this paper the authors revisit this issue within the context of an estimated medium-scale model of the U.S. economy, specifically the Smets and Wouters (2007) model.

Keywords: central banks’ objectives; simple loss function; monetary policy design; Smets-Wouters model;

JEL Classification: C32; E58; E61;

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Bibliographic Information

Provider: Federal Reserve Bank of Boston

Part of Series: Working Papers

Publication Date: 2015-03-10

Number: 15-3

Pages: 44 pages