The Output Gap: The Case Of Lithuania

Abstract

The output gap is one of the most important unobservable macroeconomic variables. Nevertheless, this issue has not been explored deeply in Lithuania so far. The thesis features a group of potential output estimation methods (linear de-trending, segmented linear de-trending, Hodrick-Prescott filter and production function) giving measures of the output gap in the Lithuanian economy for the years 1995-2005. Historically, different measures tend to co-move and indicate the same sign of the output gap. The Russian crisis stands out as the most influential event during the whole period in terms of output gap and potential GDP development. Besides, the thesis does not find evidence of significant positive relationship between the output gap and inflation in Lithuania. Finally, the thesis illustrates problems in making precise real-time gap estimations and thus ends with a range of possible values for the current state of the output gap.

Keywords: output gap, potential output.

Table of contents

COPYRIGHT DECLARATION I

ACKNOWLEDGMENTS II

ABSTRACT III

LIST OF TABLES V

LIST OF FIGURES VI

1 INTRODUCTION 1

2 LITERATURE REVIEW 3

3 ESTIMATION METHODS 5

3.1 LINEAR DE-TRENDING: SIMPLE LINEAR TREND AND SEGMENTED TREND 6

3.2 HODRICK-PRESCOTT FILTER 7

3.3 PRODUCTION FUNCTION APPROACH 8

4 DATA 11

5 EMPIRICAL FINDINGS 12

5.1 SIMPLE LINEAR METHOD: 12

5.2 SEGMENTED LINEAR TREND METHOD: 13

5.3 HODRICK-PRESCOTT FILTER 15

5.4 PRODUCTION FUNCTION 16

6 DISCUSSION OF THE RESULTS 19

6.1 CORRELATION AND CONCORDANCE STATISTICS 20

6.2 THE OUTPUT GAP AND INFLATION 22

7 HISTORICAL DEVELOPMENT OF POTENTIAL OUTPUT AND THE OUTPUT GAP 24

8 THE END-SAMPLE PROBLEM AND SOME INSIGHTS INTO THE CURRENT SITUATION 25

9 CONCLUSIONS 28

WORKS CITED 30

10 APPENDICES 33

10.1 APPENDIX 1 33

10.2 APPENDIX 2 34

10.3 APPENDIX 3 35

10.4 APPENDIX 4 36

10.5 APPENDIX 5 37

10.6 APPENDIX 6 38

List of tables

TABLE 5.1. TESTS FOR UNIT ROOT IN REAL LOGARITHMIC GDP SERIES 14

TABLE 6.1: CORRELATION STATISTICS 20

TABLE 6.2: CONCORDANCE STATISTICS 21

TABLE 6.3: RESULTS OF INFLATION MODELS 23

TABLE 6.4: CURRENT OUTPUT GAP SCENARIOS 27

List of figures

FIGURE 4.1 REAL GDP IN LITHUANIA 11

FIGURE 5.1 POTENTIAL GDP IN LITHUANIA USING SIMPLE LINEAR METHOD 12

FIGURE 5.3 POTENTIAL GDP IN LITHUANIA USING SEGMENTED LINEAR TREND MODEL 14

FIGURE 5.4 POTENTIAL GDP IN LITHUANIA, USING HP FILTER 15

FIGURE 5.5 CAPITAL STOCK IN LITHUANIA ESTIMATED VIA THE PIM METHOD 16

FIGURE 5.6 ECONOMICALLY ACTIVE POPULATION, TOTAL EMPLOYMENT AND POTENTIAL LABOR IN LITHUANIA 18

FIGURE 6.1 OUTPUT GAP IN LITHUANIA 19

FIGURE 7.1 OUTPUT GAP IN THE FIRST QUARTER OF 2002 WITH NEW INCOMING INFORMATION 27

1 Introduction

The formal definition states that the output gap is the difference between actual output (actual GDP) and the potential one, i.e. the output level with production factors fully employed .

The concept and estimation of the output gap is useful in several respects. First, the output gap in the short-run serves as an indicator of the balance between aggregate supply and aggregate demand in the economy. Negative output gap implies that aggregate demand is below aggregate supply or, alternatively, that there is excess capacity in the economy. Likewise, positive output gap means that supply is not able to satisfy demand. Substantial positive output gaps are therefore usually associated with economic overheating and all the risks coming with it, such as inflationary pressures, instability of the financial system or excessive surge of the current account deficit. Output gap's relationship with inflation is often particularly emphasized and has received substantial attention in the literature. In fact, a wide-spread alternative definition names the output gap as the maximum output of the economy that does not create inflationary pressures. Consequently, output gaps are often used to predict inflation in macroeconomic models. Furthermore, in the log-run, potential output helps to determine sustainable non-inflationary growth path for the economy. Naturally, potential output is an important variable used in assessing and constructing both monetary and fiscal policies. In general, as highlighted by Areosa, "the output gap has become one of the most important unobserved economic time series" (2004).

Unfortunately, potential output is a latent (unobservable) variable. Therefore, it has to be measured indirectly, using other economic data. Numerous techniques have been developed for that purpose. Different methods are based on different assumptions and statistical specifications. Nevertheless, there is no unanimous agreement over which type of estimation is "the right one". Therefore, usually a group of methods are used to compare various measures and get a more reliable picture.

Due to output gap's relevance, much practical and academic attention has been devoted to the topic in the developed economies. The opposite is true in the case of the Baltic States,