Potential Output and Output Gap Estimates for Nepal

Estimation of potential output and output gap is one of the key issues for the conduct of macroeconomic policies and structural reforms in the long-run. The idea of output gap helps to determine the stance of such policies and decide whether aggregate demand should be raised or structural issues should be addressed. A positive output gap, for instance, indicates that aggregate demand exceeds the productive capacity of the economy resulting into inflationary pressure. In contrast, a negative output gap is associated with recession, spare capacity, disinflation and unemployment rate above NAIRU. In case of Nepal, the potential output grew by 4.1 percent during 1976-2017. While potential output growth was higher during 1980s, fall in total factor productivity limited such growth to 4 percent on average after 1990. The output gap as percent of potential output fluctuated from -4.0 percent in 1980 to 2.1 percent to 2001. Fluctuations in output gap were larger in late 1970s and 80s but moderated during 90s and 2000s except the year 2001, 2014 and 2016 where the actual output deviated from the potential output by more than 1.5 percent. The results show that the output gaps in Nepalese case are mainly determined by the supply side shocks like weather conditions, natural disasters and supply disruptions.