Uncertainty Regarding the Output Gap and the Reaction Function Under an Inflation Targeting Regime

This paper analyzes the role of the output gap in the design of monetary policy under an inflation-targeting framework, considering the risks associated with its imperfect estimation. The study develops a theoretical model of the Central Bank’s reaction function and shows that errors in measuring the output gap can increase the volatility of inflation and output, affecting the monetary authority’s loss function. To empirically evaluate which indicator is most suitable, four alternative measures of the output gap—the Cobb-Douglas production function, a VAR model, the Hodrick-Prescott filter, and the Baxter-King filter—are estimated and compared with the real GDP growth rate using monthly data from 1992 to 2000. The results indicate that, if the primary objective is to reduce inflation volatility and improve its predictability, the output gap indicator calculated using the production function offers the best performance; conversely, if real economic objectives are also considered, the real GDP growth rate may prove to be a more balanced alternative for the conduct of monetary policy.