Finance and Economics Discussion Series (FEDS)
May 2024
Monetary Policy, Employment Shortfalls, and the Natural Rate Hypothesis
Abstract:
Activity shortfalls are more costly than strong activity. I consider optimal monetary policy under discretion with an asymmetric (activity shortfalls) loss function. The model satisfies the natural rate hypothesis. The asymmetric loss function and resulting optimal monetary policy exacerbates shortfalls in activity. The additional frequency of activity shortfalls arises from the adjustment of expectations implied by the natural rate hypothesis. The shortfalls asymmetry leads to an inflationary bias, similar to results in the time-consistency literature. Mandating a central bank objective with greater symmetry than the social loss function improves outcomes. Greater symmetry lowers the magnitude of activity shortfalls. Greater symmetry also reduces inflation bias. The model also implies that an optimal monetary policy does not accommodate fluctuations from aggregate demand shocks, as is standard in such models. As a result, the analysis implies that monetary accommodation of strength in economic activity likely requires justifications other than asymmetric costs of shortfalls.
Keywords: Monetary Policy, Rules, discretion, symmetric loss function, asymmetric loss function
DOI: https://doi.org/10.17016/FEDS.2024.032
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