Uncertain potential output: implications for monetary policy

A small forward-looking model of the euro-area economy is used to investigate the implications of incomplete information about potential output for the conduct of monetary policy. Three results emerge. First, under optimal monetary policy, output gap uncertainty leads to persistent deviations betwee...

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Bibliographic Details
Published in:Journal of economic dynamics & control 2003-07, Vol.27 (9), p.1611-1638
Main Authors: Ehrmann, Michael, Smets, Frank
Format: Article
Language:English
Subjects:
Central banks
Economic dynamics
Economic models
Economics
Euro
Europe
Monetary policy
Monetary policy rules
Output rate
Potential output
Production
Studies
Uncertainty
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Summary:A small forward-looking model of the euro-area economy is used to investigate the implications of incomplete information about potential output for the conduct of monetary policy. Three results emerge. First, under optimal monetary policy, output gap uncertainty leads to persistent deviations between the actual and the perceived output gap in response to supply and cost-push shocks. Second, in first-difference form, a simple policy rule such as the Taylor rule continues to perform relatively well as long as the output gap is optimally estimated. Third, incomplete information implies that it is optimal to appoint a more “hawkish” central bank.
ISSN:0165-1889
1879-1743
DOI:10.1016/S0165-1889(02)00073-8