Estimating the Output Gap : A Kalman Filter Approach

The output gap plays a crucial role in thinking of many inflation targeting central banks yet, the real time estimates of the output gap undergo substantial revisions as more data become available. In this paper, we use the state space framework to augment the simple Hodrick-Prescott filter with additional structural equations to i) reduce the size of revisions ii) reduce the uncertainty around the mean real time output gap estimates. We use data from New Zealand in this study. We use the relationship between output and the capacity utilisation and output and unemployment to infer the unobserved potential output.