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Inflation targeting under potential output uncertainty

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    In this paper, measures of the uncertainty surrounding estimates of New Zealand's potential output are used to consider whether the output gap is a useful concept for the monetary authority to base policy actions on. The analysis relies on stochastic simulations of the Reserve Bank of New Zealand's Forecasting and Policy System macroeconomic model (FPS). The analysis shows that when the policymakers' estimates of the output gap have large serially correlated errors that are positively correlated with the business cycle, both output and inflation become more variable. However, the output gap is still useful for stabilising output and inflation. Basing policy actions on the output gap directly and/or indirectly through forecasts of inflation leads to better macroeconomic stability than basing policy actions solely on currently available observable data such as inflation and output growth.

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    File URL: http://www.rbnz.govt.nz/research_and_publications/discussion_papers/2000/dp00_8.pdf
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    Paper provided by Reserve Bank of New Zealand in its series Reserve Bank of New Zealand Discussion Paper Series with number DP2000/08.

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    Length: 28p
    Date of creation: Apr 2000
    Date of revision:
    Handle: RePEc:nzb:nzbdps:2000/08
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    Web page: http://www.rbnz.govt.nz
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    1. Rudebusch, Glenn D & Svensson, Lars E O, 1998. "Policy Rules for Inflation Targeting," CEPR Discussion Papers 1999, C.E.P.R. Discussion Papers.
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    7. David Hargreaves, 1999. "SDS-FPS: a small demand-side version of the Forecasting and Policy System core model," Reserve Bank of New Zealand Discussion Paper Series G99/10, Reserve Bank of New Zealand.
    8. Clarida, Richard & Gali, Jordi & Gertler, Mark, 1998. "Monetary policy rules in practice Some international evidence," European Economic Review, Elsevier, vol. 42(6), pages 1033-1067, June.
    9. Peter Isard & Douglas Laxton & Ann-Charlotte Eliasson, 1999. "Simple Monetary Policy Rules Under Model Uncertainty," Computing in Economics and Finance 1999 841, Society for Computational Economics.
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    12. Edmund S. Phelps, 1968. "Money-Wage Dynamics and Labor-Market Equilibrium," Journal of Political Economy, University of Chicago Press, vol. 76, pages 678.
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    14. Taylor, John B, 1979. "Estimation and Control of a Macroeconomic Model with Rational Expectations," Econometrica, Econometric Society, vol. 47(5), pages 1267-86, September.
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    18. Hodrick, Robert J & Prescott, Edward C, 1997. "Postwar U.S. Business Cycles: An Empirical Investigation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 29(1), pages 1-16, February.
    19. Orphanides, Athanasios & Porter, Richard D. & Reifschneider, David & Tetlow, Robert & Finan, Frederico, 2000. "Errors in the measurement of the output gap and the design of monetary policy," Journal of Economics and Business, Elsevier, vol. 52(1-2), pages 117-141.
    20. Marianne Baxter & Robert G. King, 1995. "Measuring Business Cycles Approximate Band-Pass Filters for Economic Time Series," NBER Working Papers 5022, National Bureau of Economic Research, Inc.
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    23. Glenn D. Rudebusch, 1999. "Is the Fed too timid? Monetary policy in an uncertain world," Working Papers in Applied Economic Theory 99-05, Federal Reserve Bank of San Francisco.
    24. Arturo Estrella & Frederic S. Mishkin, 2000. "Rethinking the Role of NAIRU in Monetary Policy: Implications of Model Formulation and Uncertainty," NBER Working Papers 6518, National Bureau of Economic Research, Inc.
    25. Iris Claus, 2000. "Is the output gap a useful indicator of inflation?," Reserve Bank of New Zealand Discussion Paper Series DP2000/05, Reserve Bank of New Zealand.
    26. Aaron Drew & Ben Hunt, 1998. "The Forecasting and Policy System: stochastic simulations of the core model," Reserve Bank of New Zealand Discussion Paper Series G98/6, Reserve Bank of New Zealand.
    27. Ann-Charlotte Eliasson & Peter Isard & Douglas Laxton, 1999. "Simple Monetary Policy Rules Under Model Uncertainty," IMF Working Papers 99/75, International Monetary Fund.
    28. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
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    30. Hunt, Benjamin & Rose, David & Scott, Alasdair, 2000. "The core model of the Reserve Bank of New Zealand's Forecasting and Policy System," Economic Modelling, Elsevier, vol. 17(2), pages 247-274, April.
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