To Respond or Not to Respond: Measures of the Output Gap in Theory and in Practice
by Guy Segal
Bank of Israel
This paper analyzes the implications of responding to either
the model-based New Keynesian output gap or to its estimates,
and in particular, a Hodrick-Prescott-filtered output gap or a
linearly detrended output gap. Responding to these estimates
instead of to the “true” unobserved output gap generates longlasting
business cycles and lower welfare. Furthermore, correlations
between the estimates and the theoretical output gap
depend on the stochastic structure of the shocks affecting the
economy. In particular, productivity shocks generate a negative
such correlation. Hence, the output gap estimates may
provide poor guidance to monetary policy.
JEL Codes: E32, E52.
Full article (PDF, 48 pages, 6,602 kb)