Working Paper

Output gaps

Abstract: What is the output gap? There are many definitions in the economics literature, all of which have a long history. I discuss three alternatives: the deviation of output from its long-run stochastic trend (i.e., the \"Beveridge-Nelson cycle\"); the deviation of output from the level consistent with current technologies and normal utilization of capital and labor input (i.e., the \"production-function approach\"); and the deviation of output from \"flexible-price\" output (i.e., its \"natural rate\"). Estimates of each concept are presented from a dynamic-stochastic-general-equilibrium (DSGE) model of the U.S. economy used at the Federal Reserve Board. Four points are emphasized: The DSGE model's estimate of the Beveridge-Nelson gap is very similar to gaps from policy institutions, but the DSGE model's estimate of potential growth has a higher variance and substantially different covariance with GDP growth; the natural rate concept depends strongly on model assumptions and is not designed to guide nominal interest rate movements in \"Taylor\" rules in the same way as the other measures; the natural rate and production function trends converge to the Beveridge-Nelson trend; and the DSGE model's estimate of the Beveridge-Nelson gap is as closely related to unemployment fluctuations as those from policy institutions and has more predictive ability for inflation.

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2010

Number: 2010-27