A New Technique for Simultaneous Estimation of the Output Gap and Phillips Curve

A new technique to estimate simultaneously the potential output and Phillips curve is demonstrated. Here we define the potential output as the non-accelerating-inflation level of output (NLO). The NLO is not a mere trend of the actual output, but rather is a critical level of output with the following property: If the actual output is at this level, the inflation rate is neither accelerated nor decelerated. Applying our method to the data on the G7 countries, we estimate the NLO and Phillips curves and investigate their properties. It is shown that during the 1980s and 1990s, the output gap measured from the NLO was negative on average, reflecting the worldwide trend of disinflation. We also point out that the output gap has moved in accordance with corporate sentiments, and thus serves as an indicator of business conditions. In Japan, however, after the potential rate of growth dropped between 1 and 2 percent in the mid-1990s, the output gap was too volatile to allow for accurate evaluation. As for Phillips curves, a cross-country comparison shows that Japan's responsiveness of inflation to the output gap is relatively weak.