Output Gap and Inflation in the EU
Output gaps for 11 EU countries, the US and Japan are constructed based on measures of potential output derived from a CES production function. This production function accommodates differences in substitution elasticities between countries. Indeed, the empirical evidence shows that real wage elasticities of labour demand differ widely across countries. The national output gaps constructed turn out to significantly explain future changes in inflation. Moreover, the analysis also reveals that an aggregate European output gap significantly precedes aggregate European inflation, as well as inflation in the individual EU countries. These findings imply that an aggregate European output gap may serve as an inflation indicator for the preparation of a single European monetary policy.
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