Output Gap Uncertainty: Does it Matter for the Taylor Rule?

27 Pages Posted: 13 Dec 2005

See all articles by Frank Smets

Frank Smets

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

Date Written: November 1998

Abstract

This paper analyses the effect of measurement error in the output gap on efficient monetary policy rules in a simple estimated model of the US economy. While it is a well-known result that such additive uncertainty does not affect the optimal feedback rule in a linear-quadratic framework, it is shown that output gap uncertainty can have a significant effect on the efficient response coefficients in restricted instrument rules such as the popular Taylor rule. Output gap uncertainty reduces the response to the current estimated output gap relative to current inflation and may partly explain why the parameters in estimated Taylor rules are often much lower than suggested by optimal control exercises which assume the state of the economy is known.

Suggested Citation

Smets, Frank, Output Gap Uncertainty: Does it Matter for the Taylor Rule? (November 1998). BIS Working Paper No. 60, Available at SSRN: https://ssrn.com/abstract=850065 or http://dx.doi.org/10.2139/ssrn.850065

Frank Smets (Contact Author)

European Central Bank (ECB) ( email )

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+49 69 1344 6575 (Fax)

KU Leuven - Center for Economic Studies ( email )

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Belgium

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