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Designing a Simple Loss Function for the Fed: Does the Dual Mandate Make Sense?

Listed author(s):
  • Ricardo Nunes

    (Federal Reserve Board)

  • Jinill Kim

    (Korea University)

  • Jesper Linde

    (Federal Reserve Board)

  • Davide Debortoli

    (Universitat Pompeu Fabra)

Yes. Using the workhorse 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 represenst 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 objective 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.

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File URL: https://economicdynamics.org/meetpapers/2014/paper_1043.pdf
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Paper provided by Society for Economic Dynamics in its series 2014 Meeting Papers with number 1043.

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Date of creation: 2014
Handle: RePEc:red:sed014:1043
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

Web page: http://www.EconomicDynamics.org/
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