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Uncertain Potential Output: Implications for Monetary Policy

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  • Michael Ehrmann and Frank Smets

Abstract

This paper uses a small, calibrated forward-looking model of the euro-area economy to investigate the implications of incomplete information about potential output for the conduct and the design of monetary policy. Three sets of issues are examined. First, the certainty-equivalent optimal policy under both commitment and discretion is characterised. In both cases, incomplete information about potential output leads to very persistent deviations between the actual and the perceived output gap in response to supply and cost-push shocks. The costs of imperfect information are quite large. Second, the implications for simple policy rules such as a Taylor or inflation-forecast rule are examined. In first-difference form, both rules continue to perform relatively well with imperfect information as long as the output gap and the inflation forecast are optimally estimated. Third, the implications of potential output uncertainty for the optimal delegation to an independent central bank are examined. Incomplete information implies that it is optimal to appoint a more "hawkish" central bank.

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2001 with number 8.

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Date of creation: 01 Apr 2001
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Handle: RePEc:sce:scecf1:8

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Keywords: monetary policy rules; potential output; uncertainty;

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  1. Soderlind, Paul, 1999. "Solution and estimation of RE macromodels with optimal policy," European Economic Review, Elsevier, vol. 43(4-6), pages 813-823, April.
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  4. Athanasios Orphanides & Richard D. Porter & David Reifschneider & Robert Tetlow & Frederico Finan, 1999. "Errors in the measurement of the output gap and the design of monetary policy," Finance and Economics Discussion Series 1999-45, Board of Governors of the Federal Reserve System (U.S.).
  5. Victor Gaiduch & Benjamin Hunt, 2000. "Inflation targeting under potential output uncertainty," Reserve Bank of New Zealand Discussion Paper Series DP2000/08, Reserve Bank of New Zealand.
  6. Kevin J. Lansing, 2000. "Learning about a shift in trend output: implications for monetary policy and inflation," Proceedings, Federal Reserve Bank of San Francisco.
  7. Eric T. Swanson, 2000. "On signal extraction and non-certainty-equivalence in optimal monetary policy rules," Proceedings, Federal Reserve Bank of San Francisco.
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  19. Bennett McCallum, 2000. "On signal extraction and non-certainty-equivalence in optimal monetary policy rules, comments," Proceedings, Federal Reserve Bank of San Francisco.
  20. Glenn D. Rudebusch, 2002. "Assessing Nominal Income Rules for Monetary Policy with Model and Data Uncertainty," Economic Journal, Royal Economic Society, vol. 112(479), pages 402-432, April.
  21. Arturo Extrella & Jeffrey C. Fuhrer, 1998. "Dynamic inconsistencies: counterfactual implications of a class of rational expectations models," Working Papers 98-5, Federal Reserve Bank of Boston.
  22. Ben Hunt & Victor Gaiduch, 2000. "Inflation Targeting Under Potential Output Uncertainty," IMF Working Papers 00/158, International Monetary Fund.
  23. Drew, Aaron & Hunt, Benjamin, 2000. "Efficient simple policy rules and the implications of potential output uncertainty," Journal of Economics and Business, Elsevier, vol. 52(1-2), pages 143-160.
  24. Bennett T. McCallum, 1997. "Issues in the Design of Monetary Policy Rules," NBER Working Papers 6016, National Bureau of Economic Research, Inc.
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  26. Rogoff, Kenneth, 1985. "The Optimal Degree of Commitment to an Intermediate Monetary Target," The Quarterly Journal of Economics, MIT Press, vol. 100(4), pages 1169-89, November.
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