Monetary Policy, Employment Shortfalls, and the Natural Rate Hypothesis
What this paper finds — and why it matters
This paper examines optimal monetary policy under discretion when the loss function is asymmetric — placing greater weight on employment shortfalls than on equivalently sized employment strength. The model satisfies the natural rate hypothesis (NRH): monetary policy is neutral in the long run, so persistent accommodation of above-potential activity raises inflation expectations without permanently boosting employment. The central paradox the paper establishes is that an asymmetric shortfalls-oriented loss function, despite its stated goal of reducing shortfalls, exacerbates them: the mechanism runs through the NRH expectation-adjustment channel, which creates an inflationary bias structurally analogous to the Barro-Gordon result. Mandating a central bank objective that is more symmetric than the social loss function — a conservative-in-asymmetry design — lowers both the frequency of activity shortfalls and the inflationary bias. As a corollary, the analysis implies that monetary accommodation of labor market strength requires justifications beyond the asymmetric costs of shortfalls, such as permanent effects of strong labor markets on economic potential.
Summary of a forthcoming paper, AI-assisted and human-reviewed. See the linked original for the authoritative claims and full conditions.
Q1. How does the asymmetric loss function exacerbate employment shortfalls?
The mechanism runs through the natural rate hypothesis: under a loss function that places no weight on activity above potential, the optimal policy fully accommodates positive supply shocks by allowing above-potential output, but the NRH then raises the expectational baseline, making shortfalls more frequent as the perceived natural rate adjusts upward. Because the central bank treats above-potential activity as costless, it does not resist the accumulation of above-potential output in good states; expectations of future activity then rise, effectively moving the benchmark against which shortfalls are measured, and making shortfalls a more common outcome. The asymmetric policy thus generates a self-defeating dynamic: attempts to minimize shortfalls through accommodation of strength create an expectational environment in which shortfalls are more frequent.
Q2. How does the inflationary bias emerge?
The inflationary bias is structurally analogous to the Barro-Gordon (1983) time-inconsistency result: the central bank’s asymmetric desire to reduce shortfalls leads it to ease policy more aggressively than a symmetric loss function would warrant, and this tendency transmits into persistently higher inflation through the NRH expectations-adjustment channel. The classic Barro-Gordon mechanism operates through the desire to push output above its natural rate; here the analog is the desire to push activity above the shortfalls threshold. The paper’s model is constructed so that no Barro-Gordon bias exists in the baseline symmetric case, isolating the asymmetry as the sole source of the inflationary bias.
Q3. What policy prescription follows from the analysis?
The paper recommends mandating a central bank objective that is more symmetric than the social loss function, analogous to Rogoff’s (1985) conservative-central-banker result but applied to the dimension of asymmetry rather than the level of inflation aversion. A mandate that requires the CB to weight above-potential and below-potential activity more equally than society does lowers both the frequency and depth of shortfalls and reduces inflationary bias, improving welfare relative to a CB that faithfully implements the asymmetric social preference. The paper further shows that optimal policy under this design does not accommodate fluctuations from aggregate demand shocks, implying that accommodation of labor market strength requires other justifications — such as permanent productivity effects — not the shortfalls-cost asymmetry alone.
Key concepts
shortfalls asymmetry : the specification in which the central bank’s or social loss function places greater weight on employment below its natural rate than on equivalently sized employment above it; the paper’s central object of analysis.
natural rate hypothesis (NRH) : the assumption that monetary policy is neutral in the long run — persistent monetary accommodation does not permanently raise employment above its natural rate but does raise the price level; imposes the constraint that bounds the central bank’s ability to durably lower shortfalls.
inflationary bias : the systematic tendency of a central bank operating under a shortfalls-oriented asymmetric loss function to allow above-target inflation on average; emerges in this model via the NRH expectations-adjustment channel, analogous to but distinct from the Barro-Gordon result.