Filling the Gap-- Open Economy Considerations for More Reliable Potential Output Estimates

This paper argues that in open economies the Phillips-curve relationship is not sufficient to trace back the output gap, because the effect of excess demand is not symmetric across tradable and non-tradable sectors. In the non-tradable sector excess demand creates excess employment and inflation via the Phillips-curve, while in the tradable sector much of the excess demand is absorbed by the trade balance. We set up an unobserved-components model including both a Phillips-curve and a trade equation to trace back ‘sustainable’ output. We apply the model to a Greece, Ireland, Spain, Portugal, Argentina, Mexico, Korea and Hungary to test the importance of the two relationships. state-space models and Kalman-filter We find that the trade balance is more important than the Phillips-curve in identifying sustainable output. Our sustainable output estimates for euro-area periphery countries differ substantially from the potential output estimates of the European Commission and, in our view, our results can be better interpreted in light of economic developments. We also found that our model was able to correctly identify the sign of the output gap in real time, in contrast to the estimates of the European Commission. Furthermore, the revisions in our output gap estimates were smaller than the revisions of the European Commission’s estimates. NOTE: AN EARLIER VERSION OF THIS PAPER WAS ACCEPTED FOR PRESENTATION AT 2014 ECOMOD, BUT I COULD NOT OBTAIN FUNDING TO TRAVEL TO INDONESIA. THIS YEAR I WILL HAVE FUNDING TO TRAVEL TO BOSTON.