The IMF Working Papers series is designed to make IMF staff research available to a wide audience. With nearly 300 released each year, working papers cover a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.
Davide Debortoli, Jinill Kim, Jesper Lindé, and Ricardo Nunes
INTERNATIONAL MONETARY FUND
Yes, it makes a lot of sense. This paper studies how to design simple loss functions for central
banks, as parsimonious approximations to social welfare. We show, both analytically and
quantitatively, that simple loss functions should feature a high weight on measures of economic
activity, sometimes even larger than the weight on inflation. Two main factors drive our result.
First, stabilizing economic activity also stabilizes other welfare relevant variables. Second, the
estimated model features mitigated inflation distortions due to a low elasticity of substitution
between monopolistic goods and a low interest rate sensitivity of demand. The result holds up in
the presence of measurement errors, with large shocks that generate a trade-off between
stabilizing inflation and resource utilization, and also when ensuring a low probability of hitting
the zero lower bound on interest rates.