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Monetary policy and forecasting inflation with and without the output gap

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Author Info
W A Razzak (Reserve Bank of New Zealand)

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Abstract

Some observers have worried that under or over-estimating the output gap may unnecessarily induce tightening or loosening of monetary conditions, causing real fluctuations. To investigate the relationship between the output gap and inflation, we examine models of inflation that do and do not use the output gap. The Phillips curve, which relates inflation to real activity, is regarded as the maintained theory of inflation. Models of inflation without the output gap include the equation of exchange of the quantity theory of money, the real interest rate gap, and two versions of the P* model. Since none of these economic models are either totally wrong nor complete, it makes sense to diversify across models rather than relying on one model exclusively. The forecasts derived from different stable models can be combined through averaging, which offsets biases and reduces the forecast error variance. Such model diversification spreads the risks of errors (i.e., insurance about bad outcomes that arise from the reliance on a single model) and provides greater robustness for policy. This paper examines ten different models of inflation and estimates sixty-seven different specifications, some of which outperform others. Some explanatory variables like money and the real interest rate gap seem to provide more information about future inflation than does estimates of output gap.

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Paper provided by Reserve Bank of New Zealand in its series Reserve Bank of New Zealand Discussion Paper Series with number DP2002/03.

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Length: 76p
Date of creation: Mar 2002
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Handle: RePEc:nzb:nzbdps:2002/03

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Find related papers by JEL classification:
E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
C13 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods: General - - - Estimation

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References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Yap, Josef T., 2003. "The Output Gap and Its Role in Inflation-Targeting in the Philippines," Discussion Papers DP 2003-10, Philippine Institute for Development Studies. [Downloadable!]
  2. SOOREEA, Rajeev, 2007. "Are Taylor-Based Monetary Policy Rules Forward-Looking?. An Investigation Using Superexogeneity Tests," Applied Econometrics and International Development, Euro-American Association of Economic Development, vol. 7(2), pages 87-94. [Downloadable!] (restricted)
  3. Razzak, Weshah, 2003. "A Perspective on Unit Root and Cointegration in Applied Macroeconomics," MPRA Paper 1970, University Library of Munich, Germany, revised 2007. [Downloadable!]
    Other versions:
  4. Olivier Basdevant, 2003. "Learning process and rational expectations: an analysis using a small macroeconomic model for New Zealand," Reserve Bank of New Zealand Discussion Paper Series DP2003/05, Reserve Bank of New Zealand. [Downloadable!]
  5. L Christopher Plantier & Dean Scrimgeour, 2002. "Estimating a Taylor Rule for New Zealand with a time-varying neutral real rate," Reserve Bank of New Zealand Discussion Paper Series DP2002/06, Reserve Bank of New Zealand. [Downloadable!]
  6. 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. [Downloadable!]
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