Uncertain Potential Output: Implications for Monetary Policy

57 Pages Posted: 10 Feb 2003

See all articles by Michael Ehrmann

Michael Ehrmann

European Central Bank (ECB); Bank of Canada

Frank Smets

European Central Bank (ECB); KU Leuven - Center for Economic Studies

Date Written: April 2001

Abstract

This paper uses a small, calibrated forward-looking model of the euro-area economy to investigate the implications of incomplete information about potential output for the conduct and the design of monetary policy. Three sets of issues are examined. First, the certainty-equivalent optimal policy under both commitment and discretion is characterised. In both cases, incomplete information about potential output leads to very persistent deviations between the actual and the perceived output gap in response to supply and cost-push shocks. The costs of imperfect information are quite large. Second, the implications for simple policy rules such as Taylor or inflation-forecast rule are examined. In first-difference form, both rules continue to perform relatively well with imperfect information as long as the output gap and the inflation forecast are optimally estimated. Third, the implications of potential output uncertainty for the optimal delegation to an independent central bank are examined. Incomplete information implies that it is optimal to appoint a more "hawkish" central bank.

Keywords: Monetary policy rules; potential output; uncertainty

JEL Classification: E52, E31, E17

Suggested Citation

Ehrmann, Michael and Smets, Frank, Uncertain Potential Output: Implications for Monetary Policy (April 2001). Available at SSRN: https://ssrn.com/abstract=356062

Michael Ehrmann (Contact Author)

European Central Bank (ECB) ( email )

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Bank of Canada ( email )

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Canada

Frank Smets

European Central Bank (ECB) ( email )

Kaiserstrasse 29
D-60311 Frankfurt am Main
Germany
+49 69 1344 6550 (Phone)
+49 69 1344 6575 (Fax)

KU Leuven - Center for Economic Studies ( email )

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Leuven, B-3000
Belgium

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