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January 13, 2016

Seminar

How Big is the Output Gap in the Euro Area? Inflation Will Tell!

Date

January 13, 2016
12:00 - 13:15

Location

Gustav-Schmoller-Raum
DIW Berlin im Quartier 110
Room 3.3.002A
Mohrenstraße 58
10117 Berlin

Speakers

Michele Lenza, European Central Bank

We estimate a small Bayesian dynamic factor model of the euro area, including a set of real activity variables and core inflation. Our measure of the output gap is the common factor underlying the cyclical fluctuations in the variables, normalized to coincide with the deviation of output from its trend. Different reasonable specifications of our empirical model yield very different estimates of the output gap. We discriminate among the models by evaluating the accuracy of their real-time inflation forecasts. The best model forecasts inflation well and implies that after the 2011 sovereign debt crisis the output gap in the euro area has been much larger than the offcial estimates imply. Models that feature a secular-stagnation-like slow-down in trend growth, and hence a small output gap after 2011, are rejected because they do not adequately capture the inflation developments.

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