Flexible inflation targeting--how should central banks take the real economy into consideration?

Inflation targeting central banks frequently express that their policy is flexible. This means that when setting the policy rate they not only try to attain the inflation target, but also strive to stabilise real economic developments. To date, however, central banks have found it hard in practice to be precise about what stabilising the real economy means. One of the difficulties lies in defining and estimating the relevant measure of "potential output". This article describes alternative ways of defining potential output and discusses which definition is most appropriate from a monetary policy perspective. [PUBLICATION ABSTRACT]