The output gap in the monetary transmission mechanism Lavan Mahadeva Monetary Policy Committee Bank...
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Transcript of The output gap in the monetary transmission mechanism Lavan Mahadeva Monetary Policy Committee Bank...
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.