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The Output Gap and Optimal Monetary Policy

In a standard New Keynesian model, a discretionary and myopic central bank concerned with changes in the output gap and insation will implement a monetary policy that replicates the optimal, timeless perspective, precommitment policy. By stabilizing output gap changes, the central bank imparts inertia into output and insation that is absent under pure discretion. It is shown that even a fully optimizing (i.e., non-myopic) central bank operating in a discretionary policy environment achieves better social outcomes if it focuses on insation and output gap changes and not the output gap. An output gap targeting regime is found to always dominate insation targeting and to dominate nominal income targeting except when insation is primarily backward-looking or the social weight on output gap suctuations is small. Because the output gap change is equal to output growth minus growth in potential, the analysis helps explain why recent authors have found that nominal income growth targeting may be superior to insation targeting, nominal income growth depends, in part, on real output growth.