Uncertainty regarding the output gap and the reaction function under an inflation-targeting regime

This article examines the appropriateness of using output gap indicators in the design of monetary policy under an inflation-targeting framework. The research focuses on the relationship between the estimate of the output gap, inflation volatility, and the central bank’s loss function, highlighting the importance of an accurate estimate of potential output. Using monthly data from Peru between 1992 and 2000, the study applies four alternative methodologies to calculate the output gap: the Cobb-Douglas production function, a VAR model, the Hodrick-Prescott filter, and the Baxter-King filter. The results show that the output gap indicator derived from the production function minimizes inflation volatility and is the best predictor of future inflation behavior. Therefore, if the Central Bank prioritizes inflation control, the use of this indicator is recommended in the design of monetary policy. However, if it also seeks output stability, it is suggested that the real GDP growth rate be considered as an alternative. (Abstract and audio: Department of Economic Publications)