Designing Central Bank Loss Functions

Kydland and Prescott (1977) show that optimal policy proves inconsistent because of rational expectations. This paper shows that the inconsistency of optimal policy comes from the inconsistency of the social loss function with the economic structure. As a result, we delegate to the central bank a different loss function, which is consistent with the economic structure. Under the delegated loss function, consistent policy proves optimal for the social welfare. We interpret the delegated central bank loss function as an intermediate objective (an institutional mechanism) and the social loss function as the ultimate objective. The ultimate objective is optimized through the institutional mechanism