Should Monetary Policy Respond Strongly to Output Gaps?

15 Pages Posted: 8 Apr 2001 Last revised: 21 Oct 2010

See all articles by Bennett T. McCallum

Bennett T. McCallum

Carnegie Mellon University - David A. Tepper School of Business; National Bureau of Economic Research (NBER)

Date Written: April 2001

Abstract

Much recent monetary policy analysis has featured stochastic simulations with small structural macroeconomic models that include: a spending vs. saving ( IS') sector; a price-adjustment sector; and an interest rate policy rule. The first two are frequently specified so as to reflect optimizing behavior; policy may or may not be specified as optimizing depending on the study's objectives. Some leading issues concern modifications to simple quantitative optimizing models that are needed to generate realistic degrees of persistence in inflation and output-gap variables. A major policy issue is whether it is desirable for monetary policy to respond strongly to the output gap. The paper argues that the latter is unobservable and considers the implications of using a trend-type measure while the true concept is of a type more in keeping with basic theory. In such circumstances, highly undesirable consequences are likely to ensue if policy responds strongly to the measured gap.

Suggested Citation

McCallum, Bennett T., Should Monetary Policy Respond Strongly to Output Gaps? (April 2001). NBER Working Paper No. w8226. Available at SSRN: https://ssrn.com/abstract=266196

Bennett T. McCallum (Contact Author)

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