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 inßation 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 inßation 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 inßation and output gap changes and not the output gap. An output gap targeting regime is found to always dominate inßation targeting and to dominate nominal income targeting except when inßation is primarily backward-looking or the social weight on output gap ßuctuations 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 inßation targeting, nominal income growth depends, in part, on real output growth. JEL classiÞcation: E52, E58