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

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  • Frank Smets

    (European Central Bank (ECB))

Abstract

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 lower than suggested by optimal control exercises which assume the state of the economy is known.

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  • Frank Smets, 1998. "Output gap uncertainty: does it matter for the Taylor rule?," BIS Working Papers 60, Bank for International Settlements.
    • Handle: RePEc:bis:biswps:60
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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