Mind the Gap: What is the Best Measure of Slack in the Euro Area?

Angel Ubide and Kevin Ross

No 2001/203, IMF Working Papers from International Monetary Fund

Abstract: Assessing the magnitude of the output gap is critical to achieving an optimal policy mix. Unfortunately, the gap is an unobservable variable, which, in practice, has been estimated in a variety of ways, depending on the preferences of the modeler. This model selection problem leads to a substantial degree of uncertainty regarding the magnitude of the output gap, which can reduce its usefulness as a policy tool. To overcome this problem, in this paper we attempt to insert some discipline into this search by providing two metrics-inflation forecasting and business cycle dating-against which different options can be evaluated using aggregated euro-area GDP data. Our results suggest that Gali, Gertler, and Lopez-Salido's (2001) inefficiency wedge performs best in inflation forecasting and production function methodology dominates in the prediction of turning points. If, however, a unique methodology must be selected, the quadratic trend delivers the best overall results.

Keywords: WP; business cycle; Phillips curve; production function; Output gaps; unobservable components; business cycles; output gap measure; forecasting exercise; method abbreviation; consumer confidence; detrending method; output gap estimate; inflation performance criteria; Hodrick-Prescott method; non-stationary output gap; BB procedure; inflation regression; inflation dynamics; Output gap; Inflation; Potential output; survey method (search for similar items in EconPapers)
Pages: 36
Date: 2001-12-01
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Citations: View citations in EconPapers (17)

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