Estimates of potential output and the output gap are essential elements in the toolkit of policy makers. Latest changes in the European fiscal framework have strengthened significantly the role of structural budget balances, which rest on output gap calculations.
With the adoption of the Fiscal Compact new procedures are entering into force. Independent fiscal institutions are going to play an important role in triggering correction mechanisms. In our view, the new framework will be credible only if meaningful estimates of output gaps and structural budget balances are available in real time. This is a huge problem especially for small countries with short history and many structural breaks, where the estimation of output gap is more an art than a science. Very volatile estimates of output gap with weak information content can quickly undermine the credibility of independent fiscal institutions. In this working paper we critically review the current estimation techniques in Slovakia and propose a new framework to calculate more robust output gap figures. In a companion paper we deal with possible improvements in the estimation of structural budget balances.
Keywords: output gap, potential output
JEL classification: E23, C22, C32