Final answer:
c. Considers both deviations from the desired inflation rate and the output gap.
The central bank's loss function reflects its dual objectives of stabilizing inflation and managing the output gap, not just focusing on one or ignoring both.
This broader mandate that includes both inflation and unemployment is evident in central banks like the U.S. Federal Reserve, which contrasts with the single goal of inflation targeting practiced by other central banks.
Step-by-step explanation:
The rationale for the central bank's loss function reflects its objectives concerning monetary policy, particularly in addressing deviations from desired inflation rates and output gaps.
The central bank's loss function can be written as Y, which suggests that the central bank considers both deviations from the desired inflation rate and the output gap.
This is aligned with the objectives of central banks like the U.S. Federal Reserve, which, unlike inflation-targeting banks, is not solely focused on maintaining a stable inflation rate but also takes into account factors such as unemployment and economic growth. Central banks can influence macroeconomic outcomes by affecting aggregate demand through monetary policy.
Inflation targeting is an approach where the central bank's primary focus is keeping inflation within a target range. However, some central banks, like the Federal Reserve in the United States, have a broader mandate that includes both inflation and unemployment.
This difference reflects varying viewpoints on the desired degree of discretion that a central bank should have in conducting monetary policy. The broader mandate accounts for the fact that monetary policy decisions involve trade-offs, and central banks must balance multiple goals in their loss functions.