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Monetary Policy, Price Stability and Output Gap Stabilization

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  • Gaspar, Vitor
  • Smets, Frank

Abstract

Using a standard New-Keynesian model, this paper examines three reasons why monetary policy should primarily focus on price stability rather than the stabilization of output around potential, even if there appears to be an exploitable trade-off between the volatility of inflation and that of the output gap. First, we discuss the well-known time-inconsistency problem associated with active output gap stabilization. Increasing the relative weight on inflation stabilization improves the equilibrium outcome. Second, we analyse some of the problems associated with the substantial uncertainty that surrounds estimates of potential output. We argue that focusing on price stability is a robust monetary policy strategy in the face of such uncertainty. Finally, we consider the case where private agents are trying to estimate the inflation generating process using an "ad hoc", but reasonable learning rule. By emphasizing a single goal the central bank facilitates the process of learning, thereby stabilizing both inflation and the output gap. Copyright 2002 by Blackwell Publishers Ltd.

Suggested Citation

  • Gaspar, Vitor & Smets, Frank, 2002. "Monetary Policy, Price Stability and Output Gap Stabilization," International Finance, Wiley Blackwell, vol. 5(2), pages 193-211, Summer.
  • Handle: RePEc:bla:intfin:v:5:y:2002:i:2:p:193-211
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    Citations

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    Cited by:

    1. Athanasios Orphanides & John C. Williams, 2005. "Inflation scares and forecast-based monetary policy," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 8(2), pages 498-527, April.
    2. Lees, Kirdan, 2007. "How large are the gains to commitment policy and optimal delegation for New Zealand?," Journal of Macroeconomics, Elsevier, vol. 29(4), pages 959-975, December.
    3. Orphanides, Athanasios & Williams, John C., 2007. "Robust monetary policy with imperfect knowledge," Journal of Monetary Economics, Elsevier, vol. 54(5), pages 1406-1435, July.
    4. Athanasios Orphanides & John C. Williams, 2007. "Inflation targeting under imperfect knowledge," Economic Review, Federal Reserve Bank of San Francisco, pages 1-23.
    5. Orphanides, Athanasios & Williams, John C., 2005. "The decline of activist stabilization policy: Natural rate misperceptions, learning, and expectations," Journal of Economic Dynamics and Control, Elsevier, vol. 29(11), pages 1927-1950, November.
    6. Vitor Gaspar & Frank Smets & David Vestin, 2006. "Adaptive Learning, Persistence, and Optimal Monetary Policy," Journal of the European Economic Association, MIT Press, vol. 4(2-3), pages 376-385, 04-05.
    7. Kerstin Bernoth & Andrew Hughes Hallet & John Lewis, 2008. "Did fiscal policy makers know what they were doing? Reassessing fiscal policy with real-time data," DNB Working Papers 169, Netherlands Central Bank, Research Department.
    8. Vitor Gaspar & Frank Smets, 2005. "Monetary Policy under Adaptive Learning," Computing in Economics and Finance 2005 80, Society for Computational Economics.
    9. Shari Spiegel, 2007. "Macroeconomics and Growth Policies," Policy Notes 1, United Nations, Department of Economics and Social Affairs.
    10. Vitor Gaspar & Frank Smets & David Vestin, 2006. "Optimal Monetary Policy under Adaptive Learning," Computing in Economics and Finance 2006 183, Society for Computational Economics.
    11. Carl E. Walsh, 2003. "Implications of a changing economic structure for the strategy of monetary policy," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 297-348.
    12. Athanasios Orphanides & John Williams, 2004. "Imperfect Knowledge, Inflation Expectations, and Monetary Policy," NBER Chapters,in: The Inflation-Targeting Debate, pages 201-246 National Bureau of Economic Research, Inc.
    13. Klaus Schmidt-Hebbel & Carl E. Walsh, 2009. "Monetary Policy under Uncertainty and Learning: An Overview," Central Banking, Analysis, and Economic Policies Book Series,in: Klaus Schmidt-Hebbel & Carl E. Walsh & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series (ed.), Monetary Policy under Uncertainty and Learning, edition 1, volume 13, chapter 1, pages 001-025 Central Bank of Chile.
    14. Lars E. O. Svensson, 2002. "Monetary policy and real stabilization," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 261-312.
    15. Kirdan Lees, 2003. "The stabilisation problem: the case of New Zealand," Reserve Bank of New Zealand Discussion Paper Series DP2003/08, Reserve Bank of New Zealand.
    16. Rao, Nasir Hamid & Bukhari, Syed Kalim Hyder, 2010. "Asymmetric Shocks and Co-movement of Price Indices," MPRA Paper 28723, University Library of Munich, Germany.
    17. Thorsten V. Koeppl, 2009. "How Flexible Can Inflation Targeting Be? Suggestions for the Future of Canada's Targeting Regime," C.D. Howe Institute Commentary, C.D. Howe Institute, issue 293, August.
    18. Helene Schuberth, 2004. "Ziele der Geldpolitik - Die Rolle von Konjunkturstabilisierung," Wirtschaft und Gesellschaft - WuG, Kammer für Arbeiter und Angestellte für Wien, Abteilung Wirtschaftswissenschaft und Statistik, vol. 30(2), pages 177-195.
    19. Orphanides, Athanasios, 2003. "Historical monetary policy analysis and the Taylor rule," Journal of Monetary Economics, Elsevier, vol. 50(5), pages 983-1022, July.

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