Estimating Output Gap for the Turkish Economy

This paper presents a time-varying parameter methodology for constructing an estimate of output gap for Turkey. We employ the extended Kalman filter technique in a multivariate setting in which economic content is utilized by the inclusion of inflation and output gap dynamics. As a by-product, we characterize time varying nature of output gap and inflation dynamics. Several results emerge: First, we show that estimating the potential output and output gap in a multivariate setting has several advantages over univariate techniques such as the HP filter. Second, our output gap estimates confirm the historical boom-bust cycles in Turkey and point out that business cycle displays sharp turning points rather than exhibiting a smooth pattern. Third, output gap seems to have contributed dramatically to the disinflation process in 2002-2004. Fourth, estimated time varying parameters suggest that, recently, the relation between real interest rates and the output gap seems to have been converging to a more conventional one. What is more, relative impact of output gap on inflation dynamics has been rising since 2001. Putting aside the �fiscal dominance� argument, these latter findings bode well for the effectiveness of the monetary policy within the prospective inflationtargeting framework.