Monetary policy and forecasting inflation with and without the output gap

No DP2002/03, Reserve Bank of New Zealand Discussion Paper Series from Reserve Bank of New Zealand

Abstract: Some observers have worried that under or over-estimating the output gap may unnecessarily induce tightening or loosening of monetary conditions, causing real fluctuations. To investigate the relationship between the output gap and inflation, we examine models of inflation that do and do not use the output gap. The Phillips curve, which relates inflation to real activity, is regarded as the maintained theory of inflation. Models of inflation without the output gap include the equation of exchange of the quantity theory of money, the real interest rate gap, and two versions of the P* model. Since none of these economic models are either totally wrong nor complete, it makes sense to diversify across models rather than relying on one model exclusively. The forecasts derived from different stable models can be combined through averaging, which offsets biases and reduces the forecast error variance. Such model diversification spreads the risks of errors (i.e., insurance about bad outcomes that arise from the reliance on a single model) and provides greater robustness for policy. This paper examines ten different models of inflation and estimates sixty-seven different specifications, some of which outperform others. Some explanatory variables like money and the real interest rate gap seem to provide more information about future inflation than does estimates of output gap.

JEL-codes: C13 E31 E37 E52 (search for similar items in EconPapers)
Pages: 76p
Date: 2002-03
New Economics Papers: this item is included in nep-cba, nep-fin and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (15)

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