No. 260 Output Gaps and Robust Monetary Policy Rules

By Roberto M. Billi

March 2012

Abstract

Policy makers often use the output gap to guide monetary policy, even though nominal gross domestic product (GDP) and prices are measured in real time more accurately than the output gap. Employing a small New Keynesian model with a lower bound on nominal interest rates, this article compares the performance of monetary-policy rules that are robust to errors in measuring the output gap, nominal GDP level, or price level. It shows that a robust policy rule that focuses on stabilizing the price level improves the tradeoffs faced by the central bank, especially when the analysis accounts for persistent measurement errors as faced in practice.

Keywords:

nominal level targets, inertial Taylor rule, measurement errors

JEL:

E31, E52, E58