The output gap and its role in monetary policy decision-making

Release date
Vol. 66. No. 1. March 2003
Florin V. Citu; James Twaddle
Understanding the link between the real economy and inflation is essential to monetary policy formulation. In conventional macroeconomics, the concept of the output gap is an important component in that link. Used in this context, the output gap provides a useful way of thinking about inflationary pressure in the economy. This article discusses the output gap concept, its strengths and weaknesses, and how it fits into the monetary policy process at the Reserve Bank. While the output gap is a useful device in assisting the understanding and forecasting of inflation developments, it does have weaknesses. The output gap is unobservable, and developing reliable estimates of it is a key weakness. A second is the possibility that the linkage between the real economy and inflation is not well represented by models or frameworks that use the output gap concept. Being alert to these weaknesses, the Reserve Bank looks at a range of other inflationary pressure when formulating monetary policy and uses judgement where appropriate.