Speed Limit Policies: The Output Gap and Optimal Monetary Policy

Recent work on the design of monetary policy reflects a general consensus on the appropriate objectives of monetary policy. As articulated by Svensson, “....there is considerable agreement among academics and central bankers that the appropriate loss function both involves stabilizing inflation around an inflation target and stabilizing the real economy, represented by the output gap” (Lars E. O. Svensson 1999a). Such a loss function forms a key component of “The Science of Monetary Policy” (Richard Clarida, Jordi Galí, and Mark Gertler 1999), and has been widely used in recent work on policy design (e.g., Bennett T. McCallum and Edward Nelson 1999, 2000, Henrik Jensen 2001, Svensson and Michael Woodford 1999, David Vestin 2000, Marianne Nessén and Vestin 2000, and McCallum 2001). Woodford (1999a) has derived the assumptions under which a quadratic loss function in inflation and the output gap is the correct approximation to the utility of the representative agent.