Estimating potential output and output gaps for the South African economy

An economy's level of potential output plays a central (and critical) role in the formulation of monetary policy focused on maintaining low and stable inflation. Assuming that potential output is determined mainly by the quantity and quality of its productive factors and the level of technology, it follows that potential output is related to the capacity of the economy to supply goods and services. Thus the growth rate of potential output is the rate of growth that the economy can sustain for long periods of time. If the economy grows at a different rate from the potential output, then inflation will tend to adjust in response to demand pressures. In modern macroeconomic theory, one of the key sources of inflationary pressure is the difference between aggregate demand and potential output which can be quantified as the percentage difference between actual output and potential output (or the output gap). If the output gap is positive inflation tends to rise and vice versa if the gap is negative. The problem, however, is that potential output cannot be directly observed. A variety of techniques are currently used in other countries to estimate potential output, including the use of the Hodrick-Prescott filter. In this paper the various available techniques will be surveyed and applied to South African data in order to generate an economy-wide measure of potential output and the output gap.