I follow the generalized method of moments (GMM) approach of Clarida, Gali, and Gertler (1998 and 2000), which allows me to obtain estimates of the explicit or implicit response of interest rates to changes in inflation and the
output gap. Then, I examine whether the statistical relationship among interest rates, inflation, and output differs systematically based on the degree of trade openness.
Having established the potential growth rate of output at 5.5 percent, the
output gap for 2018 is the difference between the potential output for 2018 and the actual GDP figure of the same year.
The last equation introduces financial frictions (FF) and determines the lending rate which reacts to the policy rate,
output gap, financial shocks and to MaP policy:
Neither a positive or negative
output gap is ideal.
Output gap, which proxies business cycle, is the difference between current level of output in the economy and the potential level that could be supplied without putting upward or downward pressure on inflation.
Parameter [alpha] reflects the relative weight on
output gap and is expected to be less than one and closer to zero to the extent that price stability emerges as the main target for monetary authorities in all modern central banks.
The threshold value of
output gap is found 2.5% below which the response of interest rate to
output gap fluctuations is positive but above which the response is insignificant.
Kiley and Roberts derive optimal inflation targets in their two models, using three versions of a loss function that depends on inflation and the
output gap. Assuming a neutral real rate of 1 percent, the optimal inflation targets range from about 2 to 4 percent, as shown in Kiley and Roberts's figure 10.
All of the results confirm a high degree of interest rate smoothing, but the relative weights of inflation and
output gap vary across the studies.
Keywords: Structural budget balance,
Output gap, Fiscal stance, Discretionary fiscal effort
The second rule is based on a parameterization considered by Taylor (1999), in which the coefficient on the
output gap is 1.0 instead of 0.5 as in the Taylor (1993) rule.
Table 3 shows a simple version of that elasticity derived from regressing quarterly employment rates of prime-age males on the so-called
output gap (the percent difference between real GDP and potential GDP at full employment) along with a trend variable (to avoid assigning trend variation to the elasticity) and seasonal dummies.
