1. 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

2. Official rate Market rates Asset prices Exchange rate Domestic demand Net external demand Total demand Domestic inflationary pressure Imported inflation Inflation Expectations/ confidence The transmission mechanism when exchange rates are floating

3. This paper is not about different techniques to measure the output gap.

4. Flexible-price concept of the output gap/potential output

5. Comparing flexible-price output to other concepts- gapology No nominal rigiditiesflexible-price No real rigidities (in capital) + no nominal rigidities steady state Steady state

6. 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.

7. Simplifying assumptions of 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.

8. 1a.Actual economy wage eq

9. 1b. Flexible-price Wage eq

10. 1c. Steady-state wage eq

11. 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

12. 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

13. 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

14. But….. how long does it take to get to the flexible-price state?

15. And in many models, the covariance between the output gap and flexible- price output is not always zero… why? - financial market imperfections..

16. Another reason is the type of nominal rigidity... Experiment: Compare model with M&R wage equation to an AR nominal rigidity wage equation

19. 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

20. 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

22. 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.