Resuscitating the ad hoc loss function for monetary policy analysis

Working with micro-founded loss functions to derive and analyse optimal policy ensures consistency with the model used and overcomes the misleading prescriptions that result from using exogenous ad hoc loss functions. However, when allowance is made for the fact that different theories of inflation persistence can result in the same, observationally equivalent, hybrid New Keynesian Phillips curve such conclusions may no longer hold. Each theory implies its own loss function and will therefore result in different policy prescriptions. In this paper I analyse the welfare consequences of using ad hoc loss functions versus the micro-founded, but potentially incorrect, targeting rules.