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Output gaps and monetary policy at low interest rates

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  • Roberto M. Billi

Abstract

Policymakers use various indicators of economic activity to assess economic conditions and set an appropriate stance for monetary policy. A key challenge for policymakers is finding indicators that give a clear and accurate signal of the state of the economy in real time—that is, at the time policy is actually made. Unfortunately, most indicators are initially estimated based on incomplete information and subsequently revised as more information becomes available. Moreover, some indicators are based on economic concepts that are not directly observable. ; Two indicators of economic activity often used to guide monetary policy are the output gap and the growth rate of real GDP. The output gap measures how far the economy is from its full employment or “potential” level. The output gap is a noisy signal of economic activity, however, because it depends on potential GDP, which is unobservable, and because it depends on estimates of GDP that are subject to revision. In contrast, estimates of GDP growth have the advantage of being observable—albeit with a lag. But these estimates are also subject to revision as more and better underlying information becomes available. Given the possibility that either of the indicators could give an inaccurate signal in real time, should one indicator be favored over the other as a guide for policy? ; Billi uses a standard model to compare economic performance under a policy that focuses on the output gap with one that focuses on GDP growth. He concludes that policymakers should usually focus on the output gap as an indicator of economic activity when policy rates are constrained by the ZLB. A policy that focuses on GDP growth can lead to more frequent encounters with the ZLB, which, in turn, lead to more volatility in output and inflation. In failing to account for the ZLB, previous research overstated the effectiveness of a policy that focuses on GDP growth.

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Article provided by Federal Reserve Bank of Kansas City in its journal Economic Review.

Volume (Year): (2011)
Issue (Month): Q I ()
Pages:

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Handle: RePEc:fip:fedker:y:2011:i:qi:n:v.96no.1

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  1. Aoki, Kosuke, 2003. "On the optimal monetary policy response to noisy indicators," Journal of Monetary Economics, Elsevier, Elsevier, vol. 50(3), pages 501-523, April.
  2. Glenn D. Rudebusch, 2000. "Assessing nominal income rules for monetary policy with model and data uncertainty," Working Paper Series, Federal Reserve Bank of San Francisco 2000-03, Federal Reserve Bank of San Francisco.
  3. Michael Kiley, 2010. "Output gaps," 2010 Meeting Papers, Society for Economic Dynamics 266, Society for Economic Dynamics.
  4. Justin Weidner & John C. Williams, 2009. "How big is the output gap?," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue jun12.
  5. Roberto M. Billi, 2009. "Was monetary policy optimal during past deflation scares?," Economic Review, Federal Reserve Bank of Kansas City, Federal Reserve Bank of Kansas City, issue Q III, pages 67-98.
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