Working Paper: CEPR ID: DP10409
Authors: Davide Debortoli; Jinill Kim; Jesper Lind; Ricardo Nunes
Abstract: 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.
Keywords: central banks; objectives; household welfare; linear-quadratic approximation; monetary policy design; simple loss function; Smets-Wouters model
JEL Codes: C32; E58; E61
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| weight on the output gap (E23) | household welfare (I38) |
| loss function with significant weight on the output gap (E23) | welfare losses (D69) |
| interest rate smoothing (E43) | probability of hitting zero lower bound (C46) |
| loss function incorporating nominal wage inflation and hours gap (J31) | household welfare (I38) |
| weight on the output gap (higher than previously estimated) (E23) | household welfare (I38) |