Monetary Policy and the Output Gap in DSGE Models for Small Open Economies: Insights from the Czech Republic

This paper examines how alternative definitions of the output gap influence the dynamics and monetary policy prescriptions of New Keynesian DSGE models used in inflation-targeting regimes. Using the Czech economy as an example of a small open economy, we compare one exogenous and seven endogenous output-gap measures, including flexible equilibrium concepts, statistical filters, and structural approaches. The results show that endogenous identification is essential for ensuring internal consistency among business cycle fluctuations and other macroeconomic variables, while only structurally identified gaps fully exploit the advantages of the DSGE framework. Technology-augmented output emerges as the most operationally robust and conceptually coherent measure for real-side policy analysis. The findings further highlight that the policy implications of output-gap stabilization are determined by the chosen measure, which should align with the policymaker's preferences. Because these mechanisms are structural rather than country-specific, the conclusions extend to other small open economies with similar characteristics.