ABSTRACT
This chapter aims to clarify what the output gap means and why it is needed, and then link that to the practice of measurement. In monetary policy models it is common to see this effect captured by a Phillips curve where an output gap term is linked to inflation. That the Phillips curve is so common, though, belies that in practice it can be difficult to find an output gap measure that both shows a systematic relation to inflation on past data and can also be used to produce a satisfactory forecasts of future inflation. The system described by the equations is a general formulation of the transmission mechanism, and leaves out many interesting details. Static homogeneity means that the sum of the coefficients on all level nominal variables on the right-hand side of the equation of interest must be equal to the sum of the coefficients on all level nominal variables on the left-hand side.
