Monetary Policy in the Midst of a Profound Recession

BRAZIL ECONOMICS - Report 05 Dec 2016 by Affonso Pastore, Cristina Pinotti, Marcelo Gazzano and Caio Carbone

The Central Bank’s only mandate is to meet the inflation target. But its decisions are not made in a vacuum. Rather, it takes the decisions prying to minimize a loss function involving two costs: the distance of (projected) inflation from the target; and the distance of GDP in relation to potential GDP. The laudable caution of the Central Bank has been lowering the projected inflation rates, and with this the marginal cost of the distance of inflation to the target has been falling. In counterpart, actual GDP has been falling more than potential GDP (which due to the recession’s intensity has also been declining), so the marginal cost of the “output sacrifice” continues to grow steeply. Under these conditions, for a monetary authority whose only mandate is to minimize the cost of bringing inflation to the target, the necessary response is to increase the pace of monetary easing.

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