A Survey on Monetary Policy and Potential Output Uncertainty

This study provides a survey of recent theoretical and empirical works analyzing the implications of imperfect information about potential output for the conduct of monetary policy. Using small-scale New Keynesian models, most of these studies conclude that, under optimal monetary policy, output gap uncertainty leads to persistent deviations between the actual and the perceived output gap in response to supply and cost-push shocks. As a consequence, the monetary policy stance turns out to be systematically looser than under perfect information in periods of large reductions in potential output, and overly restrictive relative to this benchmark in periods of large expansions in potential output. Although these previous studies shed light on the economic mechanisms by which the imprecise measurement of potential output may affect the policy behavior and thus, the dynamics of inflation, their quantitative findings depend on the assumptions about the information set available to the policymaker. In this respect, a useful role for unit labor costs emerges. This indicator provides information about potential output, and it strongly improves the central bank’s ability to make stabilization policy more effective.