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 technology. This technology accommodates differences in substitution elasticities between countries. Indeed, the empirical evidence shows that real wage elasticities of labour demand differ widely across countries. The output gaps constructed turn out to explain movements in inflation in a statistically significant way. Moreover, an aggregate European output gap significantly preceeds inflation in the EU-countries individually as well as aggregate European inflation. These findings imply that an aggregate European output gap is a sensible indicator for inflation to be considered in the policy preparation process at the ECB.
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