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The loss function reflects the central bank’s policy objective (i.e. their preferences for stabilizing inflation and some real variable around target levels, in this case output), and it says that the central bank is concerned about inflation fluctuating from their target level ($\pi^{T}$) and their perception of the equilibrium output (here reflected in the ...


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In this case, you can interpret this as the central banks' having two mandates: output gap and inflation target. Here, the best possible scenario that would minimize the CB's loss function is having zero output gap ($\hat x^2 = 0$) and inflation is at the target ($\pi = \pi^T$). The CB simply wants to get as close to this as it could, with the "importance" ...


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