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.
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