A Multivariate Filter to Estimate Potential Output and NAIRU for the Maltese Economy

This paper applies a multivariate filter on a small macroeconomic model to derive estimates of Malta¡¯s potential output growth, the output gap and NAIRU. The unobservable variables are derived from a system that incorporates long-standing relationships in economic theory, such as the Phillips Curve and Okun¡¯s Law, while also allowing for hysteresis effects. Given the structural changes in the Maltese economy, with a shift over the past decade from traditional industries such as manufacturing towards higher-value added and export-oriented services, the model replaces a common variable used in the literature, capacity utilization in manufacturing, with two foreign variables, demand and imported inflation. The inclusion of foreign variables is important since Malta is one of the most open economies in the world with a high degree of import content. The model is also able to account for the high degree of volatility manifested in the time series of very small open economies. The estimates from the multivariate filter are compared with those derived from alternative approaches. Despite the negative impact from the financial crisis of 2009, by 2014 potential output growth had already surpassed the pre-crisis growth rates. The crisis had no permanent impact on NAIRU. This performance is clearly at odds with that of other European economies and bodes well for Malta¡¯s convergence process.