Output Gap, Monetary Policy Trade-Offs and Financial Frictions

56 Pages Posted: 2 May 2017

Date Written: May 2, 2017

Abstract

This paper investigates how the presence of financial frictions and financial shocks changes the definition and the estimated dynamics of the output gap in a New Keynesian model. Financial shocks absorb explanatory power from efficient labor supply shocks, thus changing radically the dynamics of the economy's efficient frontier. Despite their large impact on the output gap, financial factors affect the monetary policy trade-offs only to some extent. Nominal stabilization can be achieved at the cost of limited (but non-negligible) fluctuations in real economic activity. Finally, we discuss an alternative measure of the output gap (in deviation from the optimal equilibrium) that is a better measure of imbalances in the economy than the conventional output gap.

Keywords: financial frictions, output gap, monetary policy

JEL Classification: E32, C51, C52

Suggested Citation

Furlanetto, Francesco and Gelain, Paolo and Taheri Sanjani, Marzie, Output Gap, Monetary Policy Trade-Offs and Financial Frictions (May 2, 2017). Norges Bank Working Paper 8/2017. Available at SSRN: https://ssrn.com/abstract=2961667 or http://dx.doi.org/10.2139/ssrn.2961667

Francesco Furlanetto (Contact Author)

Norges Bank ( email )

P.O. Box 1179
Oslo, N-0107
Norway

Paolo Gelain

Norges Bank ( email )

P.O. Box 1179
Oslo, N-0107
Norway

Marzie Taheri Sanjani

International Monetary Fund (IMF) ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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