Potential Output and the Output Gap in Ireland

The performance of the Irish economy in recent years has been outstanding. Between 1994 and 2000, Ireland’s economic growth, as measured by the annual percentage change in real GDP (Gross Domestic Product), has expanded at an annual average rate of approximately 9 per cent. Over the same time period, we have also experienced annual employment growth of approximately 5 per cent and capital growth of around 4 per cent. Recent developments would suggest that such advances cannot continue forever. The capacity of an economy depends on the quantities of labour, capital and technology. Over time that capacity will grow because of the movement of employment from low output industries to high output modern sectors and advances in productivity brought about by improvements in technology. An economy may for brief periods operate above capacity. This is unlikely to persist in the long-run, as there will tend to be a wage and price adjustment process which will restore equilibrium. The capacity of an economy is not measured directly and must be estimated using information from other economic aggregates, which can be measured. Several methods have been proposed but there is no general agreement as to which method is best. This paper applies several of these methods to estimate the capacity of the Irish economy over the period 1960 to 2000. A broad degree of agreement was found between the various methods. Since 1997 the economy has operated above capacity. Forecasts of the capacity growth rate were outlined using estimates from ESRI (1999) and internal Central Bank estimates. This suggests that economy will be operating below capacity by 2004, when a more sustainable level of output is achieved. The output gap is defined as the difference between actual and capacity output. A positive gap (output greater than capacity) is associated with excess demand in the economy, which is a likely cause of inflation. In an open economy, such as Ireland, it is often argued that the main determinants of inflation are foreign prices and the exchange rate. The measures of the output gap derived in this paper indicate that they have some influence on overall inflation in Ireland, but the results were relatively weak. The relationship between “domestically generated” inflation and the output gap measures indicated a much stronger correlation.