Testing the Gap: An application for Uruguay.

Abstract. This paper updates previous calculations of the potential output for the Uruguayan economy under the Hodrick-Prescott filter and the Production Function Approach and introduces a new measure estimated under the SVAR. The latter methodology is based on a simple theoretical aggregate supply-demand model and the assumption that nominal shocks are neutral in the long run. The last section evaluates whether the output gaps, given the inevitable underlying uncertainty, are still a useful indicator of inflationary pressures in Uruguay. Two simple versions of the «gap model» were estimated: (a) the change in inflation related to the level of the three measures of output gap, and (b) the change in inflation related to the change in the output gap. Overall, the results suggest that the output gap, however measured, provides a good signal of inflationary threats to the monetary authorities. More precisely, when the output gap is positive (negative) four times out of five, inflation will increase (or decrease) in the next quarter and three times out of five in the next year.