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The output gap and its role in monetary policy decision-making

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  • James Twaddle
  • Florin Citu

    (Reserve Bank of New Zealand)

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    Abstract

    Understanding the link between the real economy and inflation is essential to monetary policy formulation. In conventional macroeconomics, the concept of the output gap is an important component of that link. Used in this context, the output gap provides a useful way of thinking about inflationary pressure in the economy. This article discusses the output gap concept, its strengths and weaknesses, and how it fits into the monetary policy process at the Reserve Bank. While the output gap is a useful device in assisting the understanding and forecasting of inflation developments, it does have weaknesses. The output gap is unobservable, and developing reliable estimates of it is a key weakness. A second is the possibility that the linkage between the real economy and inflation is not well represented by models or frameworks that use the output gap concept. Being alert to these weaknesses, the Reserve Bank looks at a range of other indicators of inflationary pressure when formulating monetary policy and uses judgement where appropriate.

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    File URL: http://www.rbnz.govt.nz/research_and_publications/reserve_bank_bulletin/2003/2003mar66_1citutwaddle.pdf
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    Bibliographic Info

    Article provided by Reserve Bank of New Zealand in its journal Reserve Bank of New Zealand Bulletin.

    Volume (Year): 66 (2003)
    Issue (Month): (March)
    Pages:

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    Handle: RePEc:nzb:nzbbul:march2003:1

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    1. Athanasios Orphanides & Simon van Norden, 2001. "The Unreliability of Output Gap Estimates in Real Time," CIRANO Working Papers 2001s-57, CIRANO.
    2. Orphanides, Athanasios, 2004. "Monetary Policy Rules, Macroeconomic Stability, and Inflation: A View from the Trenches," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 36(2), pages 151-75, April.
    3. Paul Conway & Ben Hunt, 1998. "Estimating the potential output of the New Zealand economy," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, vol. 61, September.
    4. Anonymous, 1997. "The Forecasting and Policy System: an introduction," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, vol. 60, September.
    5. Robert J. Hodrick & Edward Prescott, 1981. "Post-War U.S. Business Cycles: An Empirical Investigation," Discussion Papers 451, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    6. Mike Frith & Aaron Drew, 1998. "Forecasting at the Reserve Bank of New Zealand," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, vol. 61, December.
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    Cited by:
    1. El Baz, Osama, 2014. "The Determinants of Inflation in Egypt: An Empirical Study (1991-2012)," MPRA Paper 56978, University Library of Munich, Germany.
    2. Michael Graff, 2004. "Estimates of the output gap in real time: how well have we been doing?," Reserve Bank of New Zealand Discussion Paper Series DP 2004/04, Reserve Bank of New Zealand.
    3. David Hargreaves & Hannah Kite & Bernard Hodgetts, 2006. "Modelling New Zealand inflation in a Phillips curve," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, vol. 69, September.

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