This algorithm partially adjusts the estimates of the unobserved components based on the distance between the model’s forecasts of inflation and real GDP and the actual values of these variables until these statistically converge.
In the financial arena, as I will discuss, this approach often takes the form of creating incentives for market participants to monitor and control the risk-taking behavior of financial firms – that is, to exert market discipline – thereby reducing the need for direct oversight by the government.