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

  • Frank Smets

    (European Central Bank (ECB))

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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Paper provided by Bank for International Settlements in its series BIS Working Papers with number 60.

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Length: 27 pages
Date of creation: Nov 1998
Date of revision:
Handle: RePEc:bis:biswps:60
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  1. Svensson, Lars E.O., 1997. "Inflation Targeting: Some Extensions," Seminar Papers 625, Stockholm University, Institute for International Economic Studies.
  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. 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.
  5. Stephen G. Cecchetti, 1997. "Central Bank Policy Rules: Conceptual Issues and Practical Considerations," NBER Working Papers 6306, National Bureau of Economic Research, Inc.
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