The output gap in the monetary transmission mechanism

Lavan Mahadeva

Monetary Policy Committee

Bank of England

October 29-30 2004, 3rd Macroeconomic Policy Research Workshop at the National Bank of Hungary

Officialrate

Market rates

Asset prices

Exchange rate

Domestic demand

Net externaldemand

Totaldemand

Domesticinflationarypressure

Importedinflation

InflationExpectations/confidence

The transmission mechanism when exchange rates are floating

This paper is not about different techniques to measure the output gap.

Flexible-price concept of the output gap/potential output

Comparing flexible-price output to other concepts- gapology

No nominal rigidities flexible-price

No real rigidities (in capital) + no nominal rigidities

steady state

Steady state

Comparing actual, flexible-price and steady state

Strategy:

Put a Mankiw and Reis wage equation in a small GE model.

Solve the model (analytically) with a a) nominal rigidities and real rigidities,

b) without nominal rigidities,

and c) without both.

Simplifying assumptionsof the model

• Closed economy;

• Simple policy choice;

• No physical capital;

• No other nominal and real rigidities except information rigidities in wage equation;

• and only two shocks.

1a.Actual economy wage eq

1b. Flexible-price Wage eq

1c. Steady-state wage eq

Implications

• Gaps relative to the steady-state and flexible-price

a) can be far apart and b) can be composed of different shocks• Therefore we must take care for example

not to linearise around the steady-state gap and then inference about the flexible-price gap

Why is output gap meant to be useful?

• As a shock identifier- tells us if there is a trade-off or not

• and to help make the output objective more precise

Within a class of standard models

• Flexible-price state exists, unique and is stable.

• Expectation of actual economy, conditional on real shocks=flexible-price state

But… .. how long does it take to get to the

flexible-price state?

And in many models, the covariance between the output gap and flexible-price output is not always zero…why?- financial market imperfections..

Another reason is the type of nominal rigidity...

Experiment:

Compare model with M&R wage equation to an AR nominal rigidity wage equation

-1%

0%

1%

2%

3%

0 1 2 3 4 5 6 7 8 9 10 11

real and nominal shock= nominal shock only

Flexible-Price Output Gaps from the Mankiw and Reis Model following a nominal shock and a combined

nominal/real shock

Quarters following shock

-1%

0%

1%

2%

3%

0 1 2 3 4 5 6 7 8 9 10 11

nominal shock only

real and nominal shock

Flexible -Price Output Gaps from the Autoregressive model following a nominal shock and a combined nominal/real shock

Quarters following shock

Where does this leave the output gap?(1)

Key issue is nominal rigidity- until we get that right, we cannot be sure about measurement

Model-based underpinnings needed

Where does this leave the output gap? (2)

• Output gap does not summarise output objective of the transmission mechanism

• Flexible-price measurement matters not just to measure what we cannot affect, but because it affects the transmission of monetary policy

• Real rigidities matter- interaction with nominal is key

Real disqeuilibria

• Many possible measures of real disequilibria: R-R*, M-M* etc.

• All composed of demand-side shocks...

• but in different combinations to the demand-side shock component of inflation.