Central bank preferences and macroeconomic equilibrium

We investigate the behavior of an optimizing monetary authority in an economy described by a simple AS/AD model. We develop a simple methodology for deriving the optimal policy, and the associated model solution, for various forms of the authority's objectives. In our empirical work, we focus on one of these specifications, in which the authority cares about both the rate of inflation and the level of price innovations (which boost real output in our model), along the lines of Barro and Gordon (1983b). Estimating the model on post-war US data, we find that the revealed weight on price surprises is significant, but only around a third of that on inflation. The estimated elasticity of output with respect to price surprises is around one-quarter, but statistically insignificant.