Potential output and the output gap in Luxembourg: some alternative methods

The output gap is defined as the difference between the observed level of an economy's output and its trend or potential level. In the short term, an economy can produce above its potential level (a positive output gap) through unusually high levels of labour force participation, capacity utilisation, or technical progress. However, a positive output gap tends to generate inflationary pressures on the markets for factors of production. Once inflation accelerates, output will have to fall below its potential level (a negative output gap) to increase available resources and reduce the pressure on prices. Therefore, measures of the output gap are often used in macroeconomic analysis to assess current and future levels of inflationary pressures in the economy. This study reviews several of the many alternative methods of estimating output gaps and applies six of these to annual data for Luxembourg. These different measures of the output gap are then compared and evaluated in terms of their contribution to inflation forecasting. Methods based on unobserved components models tend to do better than simpler, better known methods (i.e. linear trends, the HP filter). Multivariate methods that consider the simultaneous evolution of several different economic variables tend to do better than univariate methods that limit themselves to the output series itself.