Stabilising economic fluctuations should be one of the primary objectives of central banks, perhaps even more important than stabilising near-and medium-term inflation impulses as long as long-term inflation expectations are anchored around the central banks’ inflation target. This is the conclusion of research by Davide Debortoli and colleagues published in the July 2019 issue of The Economic Journal.
The research finds that stabilising economic fluctuations can help to stabilise other important factors such as wage inflation and may help mitigate the costs of such inefficiencies.
The authors challenge the view that central banks should mainly focus on price stability. Although attaching a rather small weight to economic activity might help to establish central bank credibility for price stability during the introduction of an inflation targeting regime, once its credibility has been established, they argue that central banks should also target measures of economic activity. This is important today where elevated public debt levels following the Global Financial Crisis may limit the scope for fiscal policy to promote economic stability.
They also argue that targeting economic activity may help to address the financial cycle: adding economic activity as an explicit target on par with inflation would provide central banks with a clear reason to increase rate when the economy is running above potential even if inflation is projected to be below its target for some time.
The research uses an economic model similar to those used by central banks as a laboratory to study the implications of increasing the weight on economic activity in central banks mandates. They find that the weight that maximizes households’ welfare is higher than that considered by previous academic authors.
The key driver of these results is that targeting economic fluctuations helps stabilise other welfare relevant factors that are not included in central bank’s objectives. For example, in economies with sizable wage rigidities, stabilising economic activity is more desirable since it helps control wage inflation. But in economies where prices are much more rigid than wages, the central bank should focus on maintaining price stability, and therefore the weight placed on economic activity should be low.
According to the authors the same logic applies to other sources of inefficiencies such as labour market frictions and monopolistic power in the goods markets. In these cases, stabilising economic fluctuations may help to mitigate the costs associated with these inefficiencies.
Using a series of quantitative exercises, the study shows that the weight on economic activity should be high in a variety of scenarios including in the presence of substantial measurement errors of the output gap and shocks that generate a trade-off between inflation and economic activity.
‘Designing a Simple Loss Function for Central Banks: Does a Dual Mandate Make Sense?’ by Davide Debortoli, Jinill Kim, Jesper Lindé and Ricardo Nunes is published in the July 2019 issue of The Economic Journal.
Associate Professor at Universitat Pompeu Fabra
Professor of Economics at Korea University
Head of Research at Sveriges Riksbank
Professor at School of Economics, University of Surrey