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Potential output and the output gap in Luxembourg: some alternative methods

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  • Paolo Guarda

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Abstract

The output gap is defined as the difference between the observed level of an economy's output and its trend or potential level. In the short term, an economy can produce above its potential level (a positive output gap) through unusually high levels of labour force participation, capacity utilisation, or technical progress. However, a positive output gap tends to generate inflationary pressures on the markets for factors of production. Once inflation accelerates, output will have to fall below its potential level (a negative output gap) to increase available resources and reduce the pressure on prices. Therefore, measures of the output gap are often used in macroeconomic analysis to assess current and future levels of inflationary pressures in the economy. This study reviews several of the many alternative methods of estimating output gaps and applies six of these to annual data for Luxembourg. These different measures of the output gap are then compared and evaluated in terms of their contribution to inflation forecasting. Methods based on unobserved components models tend to do better than simpler, better known methods (i.e. linear trends, the HP filter). Multivariate methods that consider the simultaneous evolution of several different economic variables tend to do better than univariate methods that limit themselves to the output series itself.

Suggested Citation

  • Paolo Guarda, 2002. "Potential output and the output gap in Luxembourg: some alternative methods," BCL working papers 4, Central Bank of Luxembourg.
  • Handle: RePEc:bcl:bclwop:bclwp004
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    Cited by:

    1. Jimborean, Ramona, 2013. "The exchange rate pass-through in the new EU member states," Economic Systems, Elsevier, vol. 37(2), pages 302-329.
    2. Alex Durand, 2005. "Le chômage structurel dans une petite économie ouverte. Application au Luxembourg," Économie et Prévision, Programme National Persée, vol. 169(3), pages 105-126.
    3. Emilian Dobrescu, "undated". "Integration of Macroeconomic Behavioural Relationships and the Input-output Block (Romanian Modelling Experience)," EcoMod2006 272100018, EcoMod.
    4. Darrin Downes & Winston Moore, 2007. "Does the exchange rate regime influence the relationship between the output gap and the current account?," Applied Economics, Taylor & Francis Journals, vol. 39(15), pages 1955-1960.
    5. Jiri Podpiera, 2004. "Consumers, Consumer Prices and the Czech Business Cycle Identification," Working Papers 2004/04, Czech National Bank, Research Department.
    6. Patrick Lünnemann & Abdelaziz Rouabah, 2003. "Règle de Taylor: estimation et interprétation pour la zone euro et pour le Luxembourg," BCL working papers 9, Central Bank of Luxembourg.
    7. Jaromir Benes & Tibor Hledik & Jaromir Hurnik & Jiri Podpiera & Jan Vlcek, 2005. "CNB Economic Research Bulletin: Potential Output," Occasional Publications - Edited Volumes, Czech National Bank, Research Department, edition 1, volume 3, number rb03/1 edited by Vladislav Flek.

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