Estimating output gaps

Abstract

The output gap, defined as actual less potential output, is an important variable in its own right and as an indicator of incipient changes in inflation. This paper reviews five methods of estimating it for Australian GDP data, including linear time trends, Hodrick-Prescott (HP) filter trends, multivariate HP filter trends, unobservable components models and a production function model. Estimates of the gap vary with the method used and are sensitive to changes in model specification and sample period. While gap estimates at any particular point in time are imprecise, the broad profile of the gap is similar across the range of methods examined. Inflation equations are substantially improved when any measure of the gap is included, and output gaps generally explain innovations in inflation better than output growth.