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

Author

Listed:
  • James Twaddle
  • Florin Citu

    (Reserve Bank of New Zealand)

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.

Suggested Citation

  • James Twaddle & Florin Citu, 2003. "The output gap and its role in monetary policy decision-making," Reserve Bank of New Zealand Bulletin, Reserve Bank of New Zealand, vol. 66, March.
    • Handle: RePEc:nzb:nzbbul:march2003:1
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    File URL: http://www.rbnz.govt.nz/-/media/ReserveBank/Files/Publications/Bulletins/2003/2003mar66-1citutwaddle.pdf
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    References listed on IDEAS

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    4. 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.
    5. 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.
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    2. 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.
    3. Ahmad, Wasim & Sharma, Sumit Kumar, 2018. "Testing output gap and economic uncertainty as an explicator of stock market returns," Research in International Business and Finance, Elsevier, vol. 45(C), pages 293-306.
    4. 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.
    5. Wolassa L. Kumo, 2022. "Working Paper 362 - Economic Growth, Total Factor Productivity and Output Gap in Sierra Leone," Working Paper Series 2488, African Development Bank.
    6. Giuseppe Fontana & Alfonso Palacio‐Vera, 2007. "Are Long‐Run Price Stability And Short‐Run Output Stabilization All That Monetary Policy Can Aim For?," Metroeconomica, Wiley Blackwell, vol. 58(2), pages 269-298, May.
    7. Igoni Pedro & Ganiyat Adejoke Adesina-Uthman, 2022. "Impact of Monetary Policy Shocks on the Output Gap in Nigeria," International Journal of Economics and Finance, Canadian Center of Science and Education, vol. 14(9), pages 1-38, September.

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