Output Gaps and Monetary Policy at Low Interest Rates

By Billi, Roberto M. | Economic Review (Kansas City, MO), Winter 2011 | Go to article overview

Output Gaps and Monetary Policy at Low Interest Rates


Billi, Roberto M., Economic Review (Kansas City, MO)


Policymakers use various indicators of economic activity to assess economic conditions and set an appropriate stance for monetary policy. A key challenge for policymakers is finding indicators that give a clear and accurate signal of the state of the economy in real time--that is, at the time policy is actually made. Unfortunately, most indicators are initially estimated based on incomplete information and subsequently revised as more information becomes available. Moreover, some indicators are based on economic concepts that are not directly observable.

Two indicators of economic activity often used to guide monetary policy are the output gap and the growth rate of real GDE The output gap measures how far the economy is from its full employment or "potential" level. The output gap is a noisy signal of economic activity, however, because it depends on potential GDP, which is unobservable, and because it depends on estimates of GDP that are subject to revision. In contrast, estimates of GDP growth have the advantage of being observable--albeit with a lag. But these estimates are also subject to revision as more and better underlying information becomes available.

Given the possibility that either of the indicators could give an inaccurate signal in real time, should one indicator be favored over the other as a guide for policy? This article uses a standard model to compare economic performance under a policy that focuses on the output gap with one that focuses on GDP growth. A novel feature of the analysis is that it takes account of the zero lower bound (ZLB) on nominal interest rates. Previous research ignored the ZLB and implicitly allowed policymakers to set policy rates below zero.

The article concludes that policymakers should usually focus on the output gap as an indicator of economic activity when policy rates are constrained by the ZLB. A policy that focuses on GDP growth can lead to more frequent encounters with the ZLB, which, in turn, lead to more volatility in output and inflation. In failing to account for the ZLB, previous research overstated the effectiveness of a policy that focuses on GDP growth.

The first section of the article describes the challenges associated with using the output gap and GDP growth to guide monetary policy. The second section compares economic performance under such policies in the absence of the ZLB. The analysis in the third section takes account of the ZLB.

I. MEASUREMENT CHALLENGES AND IMPLICATIONS FOR POLICY

In monetary policy analysis, two commonly used measures of economic activity are the output gap and real GDP growth. While the output gap is conceptually appealing as an indicator to help guide policy, real GDP growth is measured in real time with greater accuracy. Recognizing this tradeoff, researchers have examined the use of both indicators in simple rules for monetary policy.

The output gap and GDP growth

The output gap is a gauge of how far the economy is from its productive potential. Potential output is determined by supply-side factors, such as the supply of workers and their productivity. Over the business cycle, because aggregate demand may exceed or fall short of aggregate supply, GDP may rise above or fall below potential. A typical story is that during a boom, the economy rises above its productive potential and the output gap is positive. During a recession, the economy falls below its productive potential and the output gap is negative.

The output gap is conceptually appealing because it is an important determinant of inflation developments. A positive output gap implies an overheating economy and upward pressure on inflation. By contrast, a negative output gap implies a slack economy and downward pressure on inflation. Thus, if available, accurate and timely measures of the output gap can play a central role in the conduct of effective monetary policy. A positive output gap might prompt policymakers to cool an overheating economy by raising policy rates, while a negative output gap might prompt monetary stimulus. …

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