Mandates and Monetary Rules in a New Keynesian Framework

Abstract

We develop a general mandate framework for delegating monetary policy to an instrument-independent, but goal-dependent central bank. The goal of the mandate consists of: (i) a simple quadratic loss function that penalizes deviations from target macroeconomic variables; (ii) a form of a Taylor-type nominal interest-rate rule that responds to the same target variables; (iii) a zero-lower-bound (ZLB) constraint on the nominal interest rate in the form of an unconditional probability of ZLB episodes and (iv) a long-run (steady-state) inflation target. The central bank remains free to choose the strength of its response to the targets specified by the mandate. An estimated standard New Keynesian model is used to compute household-welfare-optimal mandates with these features. We find two main results that are robust across a number of different mandates: first, the optimized rule takes the form of a Taylor simple rule close to a price-level rule. Second, the optimal level of inflation target, conditional on a quarterly frequency of the nominal interest hitting the ZLB of 0.025, is close to the typical target annual inflation of 2% and to achieve a lower probability of 0.01 requires an inflation target of 3.5%.