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Designing Central Bank Loss Functions

  • Huiping Yuan

    (Department of Finance, Xiamen University, China)

  • Stephen M. Miller

    (Department of Economics, University of Nevada¡XLas Vegas, U.S.A.)

Kydland and Prescott (1977) consider the issue of the time-inconsistency of optimal policy and its source. Our paper provides additional insight on this issue. They develop a simple model of monetary policy making, where the central bank needs some commitment technique to achieve optimal monetary policy over time. Although not their main focus, they illustrate the difference between consistent and optimal policy in a sequential-decision one-period world. In our solution, the government appoints a central bank or delegates to the central bank an objective function that differs from the social welfare function. The central bank’s welfare function causes the consistent policy implemented by the central bank to prove optimal for society. The optimal institutional design for the Kydland-Prescott sequential-decision one-period model requires the appointment or delegation to a completely conservative central banker.

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Article provided by College of Business, and College of Finance, Feng Chia University, Taichung, Taiwan in its journal International Journal of Business and Economics.

Volume (Year): 9 (2010)
Issue (Month): 1 (April)
Pages: 77-81

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Handle: RePEc:ijb:journl:v:9:y:2010:i:1:p:77-81
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  1. Svensson, Lars E O, 1995. "Optimal Inflation Targets, 'Conservative' Central Banks, and Linear Inflation Contracts," CEPR Discussion Papers 1249, C.E.P.R. Discussion Papers.
  2. Robert J. Barro & David B. Gordon, 1983. "Rules, Discretion and Reputation in a Model of Monetary Policy," NBER Working Papers 1079, National Bureau of Economic Research, Inc.
  3. Calvo, Guillermo A, 1978. "Some Notes on Time Inconsistency and Rawls' Maximin Criterion," Review of Economic Studies, Wiley Blackwell, vol. 45(1), pages 97-102, February.
  4. Andrew Hughes Hallett & Diana N. Weymark, 2002. "Independence Before Conservatism: Transparency, Politics, and Central Bank Design," Vanderbilt University Department of Economics Working Papers 0202, Vanderbilt University Department of Economics.
  5. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
  6. Andrew Hughes Hallett & Diana N. Weymark, 2006. "Heterogeneity In A Currency Union With Social Market Objectives," Scottish Journal of Political Economy, Scottish Economic Society, vol. 53(1), pages 129-152, 02.
  7. Robert J. Barro & David B. Gordon, 1981. "A Positive Theory of Monetary Policy in a Natural-Rate Model," NBER Working Papers 0807, National Bureau of Economic Research, Inc.
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