Designing a Simple Loss Function for Central Banks: Does a Dual Mandate Make Sense?

Abstract

Yes, it makes a lot of sense. Using the Smets and Wouters (2007) model of the U.S. economy, we …nd that the role of the output gap should be equal to or even more important than that of in ation when designing a simple loss function to represent household welfare. Moreover, we document that a loss function with nominal wage in ation and the hours gap provides an even better approximation of the true welfare function than a standard objective based on in ation 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.