, this would be equivalent to stabilizing inflation. 7 a great deal of work is being done on this class of models. for example, many researchers are attempting to build richer models that have a more elaborate financial sector in light of the recent financial crisis, and they are incorporating frictions of various kinds. regardless of how these models are enhanced, their concept of the gap will continue to be a deviation of output from the efficient level that would prevail in the absence of nominal rigidities and market imperfections. therefore, the gap in these models will remain conceptually different from a gap based on potential output. and there is no reason to believe that the policy prescriptions based on these gaps will be the same. indeed, the nature of the shock will be an important determinant in whether the efficient output level changes and whether monetary policy should react or not. conclusion policymakers need a framework with which to evaluate incoming data in order to set appropriate monetary policy. but the recession and recovery have underscored that we must remain humble about our degree of understanding of the economy and that we must entertain various perspectives in setting policy. as i ’ ve discussed, there are several different ways to interpret the economic dynamics we have seen in recent years, and those perspectives would call for different policy responses. some view the shocks hitting the economy as transitory and potential gdp as stable. others view the shocks as being more permanent, affecting both actual and potential output. in addition, there are alternative concepts of the output gap itself, some of which focus on the efficient level of output instead of potential output. each of these perspectives has some merit as well as drawbacks, and it will be some time ( if ever ) when we will know which perspective is the correct one in explaining our recent economic experience. this state of affairs has led me to be skeptical of relying on gaps in general as well as optimal control exercises that are derived from specific models. instead, i have long advocated that we should think in terms of robust policies that yield good economic see jordi gali and olivier blanchard, “ real wage rigidities and the new keynesian model, ” journal of money, credit and banking, 39 ( 2007 ), pp. 35 – 65 and aubhik khan, robert g. king, and alexander l. wolman, “ optimal monetary policy, ” review of economic studies, 70 ( 2003 ), pp. 825 – 860. bis central bankers ’ speeches outcomes across a variety

some empirical research that charles nelson and i published in the journal of monetary see figure below. congressional budget office, “ a summary of alternative methods for estimating potential gdp, ” background paper, march 2004, p. 1. bis central bankers ’ speeches economics over three decades ago. 3 in that paper, we concluded that real output contained important stochastic trends. a stochastic trend is often characterized as a random walk. a particular feature of a random walk is that it doesn ’ t exhibit any mean reversion. it means that the stochastic shocks that drive such a series accumulate. put another way, each shock is permanently embodied in the level of the series – there is little tendency to return to a previous trend line. such shocks are the antithesis of transitory, or what some refer to as cyclical, shocks that, by definition, dissipate over time. in our analysis, nelson and i assumed that the economy was buffeted by a mixture of permanent and transitory shocks. such a framework is not unusual and is compatible with the type of permanent and transitory distinction stressed in milton friedman ’ s permanent income hypothesis. 4 more generally, in dynamic models, forward - looking agents ’ responses to permanent shocks can be quite different from their responses to transitory shocks. for example, in the permanent income framework, agents adjust consumption much more in response to changes in permanent income than to temporary changes in income. our statistical analysis found that a large portion of the fluctuations in real gdp were the result of shocks to the stochastic trend, that is, permanent shocks. interestingly, the recent recession saw a marked drop in consumption. some of this decline may have been due to credit constraints that became binding on some consumers. but some of the decline likely reflected the fact that many consumers now perceived that their permanent income had fallen, so they reduced their level of consumption. looking at the figure, we see that the behavior of the gdp suggests that in the recent recession, the u. s. economy sustained what appears to be a permanent or at least highly persistent shock to the supply side of the economy that has lowered the level of gdp – although not necessarily its growth rate. one could contemplate numerous hypotheses about the nature of such a shock. in 2009, i put forward the idea that the crisis and recession were caused by a shock that likely had either permanent or very long - lasting consequences for the economy. i suggested that the financial crisis may