Implementing Optimal Monetary Policy: Objectives and Rules

We observe that the inconsistency of optimal policy comes from inconsistency of the social loss function with respect to the economic structure. Accordingly, this paper designs the central bank loss functions and rules, which are consistent with the economic structure and serve as mechanisms to implement optimal policy. We minimize the social loss function and use the idea of implementation theory, in designing the central bank loss functions and policy rules. Both ways result in identical central bank loss functions and policy rules. We also examine four equivalent methods of implementing optimal monetary policy, committing to the social loss function, using discretion with the central bank long-run and short-run loss functions, and following monetary policy rules. The same outcomes emerge from these different policymaking methods because the central bank actually follows the same (similar) policy rules. To some extent, policy rules appear more basic and flexible than social and central bank loss functions. In addition, we observe that the short-run natural employment target eliminates both the average and the state-contingent inflation biases, and a liberal, not conservative, preference eliminates the stabilization bias. As a result, under the designed central bank loss function discretionary policy proves optimal for social welfare. In conclusion, the social loss function, the central bank long-run and short-run loss functions, and monetary policy rules imply a complete regime for implementing optimal policy.