Mind the Gap: Structural and Nonstructural Approaches to Estimating Israel's Output Gap

This paper reviews various methods of estimating the output gap, and applies two of them to Israel’s economy—the production-function method, and estimating structural vector auto-regression (SVAR), both structural methods. The production function method focuses on dividing factors of production into a trend and a cyclical component, and also breaks down the Solow residual into productivity and capital utilization. The SVAR method also breaks output down into trend and cyclical components, via long-term constraints. As there are various definitions of potential output (that which does not produce inflationary pressures, and long-term output), the paper shows how it can be measured in accordance with the chosen definition. An estimate of the Phillips curve equation yields the result that estimates of the output gap by both methods have a positive effect, consistent with economic theory, on price volatility. The results of the estimate give rise to several conclusions: (1) the annual rate of growth of potential output in the second half of the 1990s declined by about one percentage point from the rate in the first half. (2) Estimates of the output gap including start-ups do not differ significantly from estimates excluding them. This result must be treated with caution, however, due to the small number of observations with data on start-ups. (3) It is clear that the business cycle at the beginning of the 1990s derived mainly from supply shocks (in particular the influx of immigrants), while the recession that started in 1996 was due to demand shocks.