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Output gap uncertainty: Does it matter for the Taylor rule?

  • Frank Smets

    ()

    (ECB, D-60311 Frankfurt am Main, Germany)

This paper analyses the effect of measurement error in the output gap on efficient monetary policy rules in a simple estimated model of the US economy. While it is a well-known result that such additive uncertainty does not affect the optimal feedback rule in a linear-quadratic framework, it is shown that output gap uncertainty can have a significant effect on the efficient response coefficients in restricted instrument rules such as the popular Taylor rule. Output gap uncertainty reduces the response to the current estimated output gap relative to current inflation and may partly explain why the parameters in estimated Taylor rules are often much less than what optimal control exercises which assume the state of the economy is known suggest.

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Article provided by Springer in its journal Empirical Economics.

Volume (Year): 27 (2002)
Issue (Month): 1 ()
Pages: 113-129

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Handle: RePEc:spr:empeco:v:27:y:2002:i:1:p:113-129
Note: received: September 2000/Final version received: February 2001
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  1. Lars E. O. Svensson, 1997. "Inflation Targeting: Some Extensions," NBER Working Papers 5962, National Bureau of Economic Research, Inc.
  2. Clark, Peter K., 1989. "Trend reversion in real output and unemployment," Journal of Econometrics, Elsevier, vol. 40(1), pages 15-32, January.
  3. Stephen G. Cecchetti, 1995. "Inflation Indicators and Inflation Policy," NBER Working Papers 5161, National Bureau of Economic Research, Inc.
  4. Stephen G. Cecchetti, 1997. "Central Bank Policy Rules: Conceptual Issues and Practical Considerations," NBER Working Papers 6306, National Bureau of Economic Research, Inc.
  5. Henderson, Dale W. & McKibbin, Warwick J., 1993. "A comparison of some basic monetary policy regimes for open economies: implications of different degrees of instrument adjustment and wage persistence," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 221-317, December.
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