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Output Gap Estimation and Monetary Policy with Imperfect Knowledge

Pei Kuang, Kaushik Mitra () and Li Tang
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Pei Kuang: University of Birmingham
Li Tang: Middlesex University

Discussion Papers from Department of Economics, University of Birmingham

Abstract: We analyze stability of a large number of recommended output gap estimation methods and their monetary policy implications – not studied in the existing literature – in a New Keynesian model where the policymaker estimates the output gap over time. A sufficiently large response to inflation and small response to output gap estimates robustly delivers good welfare performance, irrespective of the choice of detrending methods. Across all methods, while the optimal response to inflation is similar in magnitude, that to output gap estimates varies considerably. Methods that intrinsically produce large and volatile output gap estimates are prone to self-reinforcing deflation spirals with large welfare loss; the optimal response to output gap estimates in these methods is small.

Keywords: Detrending; Monetary policy; Expectations; Learning; Inflation; Welfare (search for similar items in EconPapers)
JEL-codes: C18 E17 E32 E52 (search for similar items in EconPapers)
Pages: 80 pages
Date: 2022-07
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
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