The contribution of the output gap in the conduct of inflation targeting in the Philippines
Date
2004-03
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Abstract
This paper evaluates whether the inclusion of the output gap in the central bank's estimated reaction function would improve the conduct of inflation targeting in the Philippines. A reduced-form vector autoregression model was constructed using the exchange rate, the output gap, inflation, and the interest rate as the relevant variables. The authors use two measures for the short-term interest rate, namely the RRP rate and the T -bill rate. Results from counterfactual simulations show that the adoption of a Taylor-type rule which involves the use of the output gap minimizes the deviations of inflation from its target.
In particular, the output gap estimates derived from the Hodrick-Prescott Filter registered the lowest root mean square errors from the target. The models which correspond to the HP- filtered gaps yield simulated rates of inflation that outperform those which correspond to the gap estimates derived from the Unobservable Components method and the time trend model.
Based on the empirical results of this study, the inclusion of the output gap is significant in terms of its contribution to maintaining inflation at a level that is nearer to the desired target. It is recommended that further studies consider the use of output gap estimates derived from other procedures, especially those which employ Markov-regime switching techniques which could account for shocks in the economy. In addition, the use of alternative model- representations for the Philippine economy within which counterfactual simulations may be performed is recommended as an area for future research.
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Inflation, Fiscal policy, Monetary policy, Output gap, Inflation targeting