Intuitive and Reliable Estimates of the Output Gap

Kamber, Gunes and Morley, James and Wong, Benjamin (2018) Intuitive and Reliable Estimates of the Output Gap. The Review of Economics and Statistics, 100 (3). pp. 550-566. ISSN 0034-6535

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Abstract

The Beveridge-Nelson decomposition based on autoregressive models produces estimates of the output gap that are strongly at odds with widely held beliefs about transitory movements in economic activity. This is due to parameter estimates implying a high signal-to-noise ratio in terms of the variance of trend shocks as a fraction of the overall forecast error variance. When we impose a lower signal-to-noise ratio, the resulting Beveridge-Nelson filter produces a more intuitive estimate of the output gap that is large in amplitude and highly persistent, and it typically increases in expansions and decreases in recessions. Notably, our approach is also reliable in the sense of being subject to smaller revisions and predicting future output growth and inflation better than other trend-cycle decompositions that impose a low signal-to-noise ratio.