Working paper No. 103
By Mark S Astley and Tony Yates
This paper outlines some problems with the methods often used to construct measures of real ‘disequilibria’ or ‘gaps’ (eg the output gap), and to examine their relation to inflation. It then offers a structural vector autoregression alternative, which we use to construct estimates of output, unemployment and capacity utilisation gaps. We construct our gap estimates by summing the effects of particular structural shocks on output etc – where the shocks are identified using long-run restrictions derived from theory. Our approach has four main advantages over other methods. First, it uses economics rather than statistics to construct the gaps. Second, the estimates are not contingent upon particular assumptions about the structure of the economy. Third, it does not impose a rigid causal chain running from gaps to inflation. Fourth, it allows us to construct several gaps and examine their relation to inflation in a single framework – so our three gaps are internally consistent and can be used to make inferences about the structure of the economy.