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Differences in monetary policies between two hypothetical closed economies:one which is concerned with avoiding a large negative output gap and the other which is not

Gunaratna, Thakshila (2014): Differences in monetary policies between two hypothetical closed economies:one which is concerned with avoiding a large negative output gap and the other which is not.

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Abstract

This research is focused on the effect of varying output gap target bounds on monetary policy. Here, a mathematical theory known as the ‘Viability Theory’ is employed to approach this problem in the context of satisficing policies, as discussed by Nobel Prize winning Herbert Simon, [see Simon (1955)]. A closed economy’s monetary policy problem of controlling inflation is considered to be this sort of satisficing policy problem. The viability theory is used to form viability kernels (using VIKAASA), which are a collection of points from which evolutions can start and remain within a certain constraint set K given some restricted controls, [see Krawczyk and Kim(2009)]. Using VIKAASA one can build such kernels for various exogenously defined constraint sets K and policy instruments. This study contributes in filling a gap of knowledge about what the viable economic states are if the output gap is targeted. The main results of this research show that, when smaller than historically acceptable output gaps are targeted, the central banks should avoid high level inflation at extreme positive output gaps, while at lower output gap limits very small inflation should also be avoided. The former prescription should be realised by having higher level interest rates and the latter by having lower level interest rates. Early interest rates adjustments are always recommended for central banks to avoid extreme situations.

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