Assessing the output gap's risk in inflation targeting: a loss function approach
Date
2009-03
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Abstract
Output gap is the difference between the economy's actual output and potential output, potential output being the level of production that can be sustained with the existing labor, capital and given state of technology. Output gap is indicative of supply and demand pressures in the economy that can cause fluctuations in the inflation rates.
Various countries have adopted the output gap as a reliable indicator of domestic inflationary pressures, citing that a positive output gap is indicative of demand pressures. In the Philippines, Josef Yap of P.I.D.S. and Bagsic and McNelis of the B.S.P., the Philippines' central bank, provided literature for output gap in the Philippine context. Yap suppmted the use of output gap in inflation targeting. Bagsic and McNelis found uncertainty in output gap estimation, albeit favoring its use.
The findings of Yap and Bagsic and McNelis have placed an uncharted region to be discussed: if the output gap is indeed an indicator of inflationary pressure, what were the risks of the current monetary policy of the BSP, which is inflation targeting'? What was the output gap for the Philippines? A period loss function of an inflation targeting based central bank was employed in order to investigate this inquiry. Data on output gap, interest rate, inflation rate from the first quarter of 1990 to the third quarter of 2008 was used in the analysis.
Three significant results were found in the pursuit of the inquiry. First, the output gap is a significant variable in predicting the future trend in inflation, which is vel)· helpful for the central bank to set their monetary)· targets. The interest model confirmed structural assumptions that the intercept, or the Taylor rule, would indeed dictate optimal stabilization policy. Second, the injection of output gap to the inflation model improved the equation suggesting the usefulness of including output gap in the inflation model using the Philippine data. However, since 2008, the risk of wrong monetary)· policy has risen significantly.
The BSP has been inconsistent with its success in minimizing the cost of monetary policy. In the eight- year span of macroeconomic data, there are durations of high-risk of monetary policy, briefly touching the optimal policy rate and then threading high risk once more.
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Keywords
Output gap, Inflation targeting, Inflation, Monetary policy, Loss function approach, Inflation risk