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ECON 304 Lecture Notes - Wage, Dynamic Stochastic General Equilibrium, Output Gap

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ECON 304
Jean- Paul Lam

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Economics 304 - Winter 2013
Monetary Theory
Jean-Paul Lam
Monetary Policy in Canada and the US: Part 2
In the previous lecture, we present a detailed analysis of howmonetarypolicyisimplementedin
Canada. While the objective of monetary policy in Canada and in many other countries is simple,
that is to target a given level of the CPI, achieving this objective is complex. In this lecture, we
give an overview of some of the data that the staand governingcouncilusetocometoadecision
regarding the level at which they should set the overnight rate.
In formulating monetary policy, central banks have to deal with substantial uncertainty. Uncer-
tainty is often pervasive and can come from numerous sources and can take many forms. Uncertainty
can be grouped under three categories: data, model and shock.Thedatausedbyeconomistscon-
tain errors and are often subject to revisions. For example, GDP in Canada published by Statistics
Canada every quarter is often revised as new information is revealed, new methodologies are im-
plemented and/or mistakes are discovered. As central banks have to take decisions in real time
but use data that are often revised, this source of uncertainty complicates the conduct of monetary
Central banks have to make forecasts about the economy and they use various models to forecast
important macro variables such as inflation, GDP and the exchange rate. The forecasts will thus
heavily depend on the types and accuracy of the models they use. As models are not perfect,
there is always an inherent uncertainty when using them. There is also uncertainty regarding the
relationship between variables in a given model and the values that these variables take.
Parameter uncertainty arises when central banks are unsure how changes in one variable aect
the other (size and direction). For example, how much does inflation and GDP change following
a 1% increase in the interest rate? Dierent models and dierent methodologies will give dier-
ent answers. In addition, often the confidence interval surrounding point estimates is large and
the relationship between variables can change over time due to structural changes. This type of
uncertainty also complicates the conduct of monetary policy.
Typically central banks respond more cautiously the bigger the uncertainty regarding the pa-
rameters of the model. This is the essence of “Brainard principle”. The Brainard Principle basically
states that policy-makers should exhibit conservatism and be more cautious in the face of parameter
Central banks also face uncertainty regarding the nature anddurationofeconomicshocks.
They observe changes in macro variables but often do not know the cause of the changes. As
the policy response of a central bank can depend on the nature and duration of the shock, it is
therefore important for them to know the nature of the shock. For e xam ple, su pp ose th e ce nt ral
bank observes a significant increase in real wages. If real wages are increasing because of a shock

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to nominal wages but production remains the same, then this increase in wages will likely trigger
inflation in the future as firms will pass on the rising costs to consumers. In this case, the central
bank should be forward looking and take the appropriate actions to contain any future increases
in prices. On the other hand, if real wages are increasing because of a rise in productivity, in this
case, the central bank should not react as this increase in wages is not likely to trigger inflation in
the future.
Central banks deal with these various sources of uncertaintyinanumberofways. Monetary
policy nowadays is conducted in a era of rich data. Central banks take advantage of this by
analyzing data on various sectors and parts of the economy. The staat the Bank of Canada
monitors a large number of data. While the focus is on macro data, they also pay a lot of attention
to micro data on households and firms.
Central banks also use dierent models to forecast the economy. Since there is a great deal
of uncertainty regarding the forecast of any given model, central banks typically employ dierent
types of models (size, transmission mechanism). The staat the Bank of Canada uses various
models to provide information to governing council. Most of the models used at the Bank of
Canada are structural models. The main projection and policy-analysis model used at the Bank
of Canada is called TOTEM (Terms-of-Trade Economic Model). It is an open-economy, dynamic
stochastic general equilibrium model (DSGE) that is estimated to provide forecasts and policy
recommendation to governing council.
They pay particular attention to the various measures of pressures on capacity such as the
output-gap, capacity utilization, vacancy rates and unit labour cost. The output-gap is a very
important variable central banks pay attention to as the latter is assumed to be a key driver of
In this section, we present some of the information and data used by the Bank of Canada in
the formulation of monetary policy. The approach followed bytheBankofCanadaregardingthe
setting of the target overnight interest rate is based on models and data pertaining to the Canadian
and overseas economies. One of the central components of thisprocessisamajorbriengbythe
Bank stato Governing council. This briefing is focused around the analysis prepared by the sta
based on forecasts and projections coming from the dierent models used by the Bank, in particular
TOTEM, information from surveys conducted by the regional oces (Senior Loans Ocer Survey
and the Business Outlook Survey), information from nancialvariables,inparticularrmsand
households credit data and information from financial markets, in particular market expectations
regarding inflation and interest rates.
We present an overview of the dierent types of information that the Bank of Canada use in
coming to a decision regarding interest rates. We begin with measures of capacity pressures and
focus on the output-gap which is one of the key variable they use.1
3.1 The output-gap
1This section of the notes borrows partly from “Information and Analysis for Monetary Policy: Coming to a
Decision” by TiMacklem, Bank of Canada Review Summer 2002.

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The output-gap is the dierence between the economy’s actual output (GDP) and the level of
production it can potentially produced. This potential output represents the amount of output
an economy can achieve with existing labour, capital, and technology without putting sustained
upward pressure on inflation.
The gap is positive when actual output exceeds the economy’s potential and negative when
actual output is below potential output. A positive output gap is also referred to as excess demand
and a negative output gap is referred to as excess supply. Since positive (negative) output-gaps
are associated with excess demand (supply), they are often used as indicators of capacity pressure
in the economy. Excess demand and hence a positive output-gapisoftenregardedasanearly
indication of increases in future inflation.
When spending in the economy is high in relation to capacity, this tends to put upward pressure
on prices. Conversely, a low rate of spending tends to put downward pressure on prices. This
relationship can also be expressed in the reverse manner—if the rate of inflation begins to increase,
it is typically a sign that spending levels are approaching the economy’s level of potential output
and that output growth is not sustainable. Conversely, if therateofinationisconsistentlybelow
expectations, this is a sign of continuing slack (excess capacity) in the economy.
The Bank of Canada is concerned about both too much and too little demand in the economy
when either puts sustained upward or downward pressure on prices (remember the Bank of Canada
tries to keep inflation within the 1-3% and, aiming for the middle of the band). Thus, when the
output gap is thought to be small and demand is seen to be increasing faster than potential output,
the Bank of Canada will typically act to tighten monetary conditions to curb demand and the
inflationary pressures. If the economy can be kept from overheating, then it will be less likely that
even tighter monetary conditions will be required later to control inflation.
3.2 The output-gap and inflation
We saw that a p ositive output-gap is an indication of excess demand in the economy and as we
mentioned earlier, a positive output-gap is often a signal that there will be pressure on prices to
increase in the future. The link between the output-gap and inflation can be summarized by the
Phillips curve. We will develop the Phillips curve in the coming lectures. For now, assume that
the output-gap at time tis given by xt,inationbyπt.ThetypicalPhillipscurvethattheBank
of Canada use in their models take the following form:
πt=βEtπt+1 +κxt+$t(1)
βand κare parameters and $tis an exogenous shock to inflation. The above equation is a forward-
looking Phillips curve. In this equation, inflation at time tdepends on expected future inflation,
the output-gap and an inflation shock. If xtis positive, the output-gap is positive, implying there
is an excess demand in the economy. If this is the case, there will be pressure on inflation to
increase. Inflation also depends on expected inflation, a key driver. The Phillips curve is a very
good representation of how excess demand or supply and inflation expectations aect inflation.
This forward-looking Phillips curve implies that the central bank can eectively reduce inflation
through two channels. By reducing inflation expectations and/or by increasing the policy rate so
that the output-gap becomes negative. A reduction in inflation expectations can come from the
policy actions of the central bank but it can also come from announcements from the central bank.
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