The main aim of the following research is to explain the meaning and content of the output gap and on the basis of widely accepted methods to measure output gap for Georgia.
The output gap is an indicator of the economic cycle. The output gap measures deviation of the actual output from its potential level. Potential output can be described as the maximum level of output that could be achieved by maximum utilization of resources while maintaining stable inflation. Thus, the output gap is often applied for assessment of economic activity with respect to its potential level.
Why the assessment of the output gap is important? Output gap plays an important role in forming fiscal (budget) and monetary policy, because it gauges the level of economic activity with regard to its potential level and measures the inflationary pressure from demand side. In particular, under high economic activity when actual output exceeds its potential level (positive output gap), with response to excess aggregate demand fiscal policy tightening (increase taxes and/or reduce government spending) can be used. Namely, tight fiscal policy can create disincentives for production and employment that will reduce aggregate demand and economy will return to its equilibrium level. By contrast, when actual output is lower than its potential level (negative output gap) expansionary fiscal policy (reduce taxes e.g. reduce profit tax and/or increase government spending e.g. increase capital spending) can be adopted to stimulate aggregate demand and close negative output gap. Implementing fiscal policy based on abovementioned logic is called anti-cyclical fiscal policy (see Parliamentary Budget Office’s research paper “Main Aspects of Fiscal Policy Influence”).
The output gap can play a role in monetary policymaking as it determines inflationary pressure. Particularly, positive output gap generates upward inflationary pressure. In this case, central bank can adopt tight monetary policy by raising interest rate in order to mitigate inflationary pressure from the demand side. Contrary, when actual output is less than its potential level, with response to low demand prices tend to reduce. Therefore, central bank can use expansionary monetary policy by lowering interest rate in order to mitigate deflationary pressure from the demand side.
What is the trend of the output gap for Georgia? Potential output of the economy can not be directly observed. However, various statistical methods can be used to estimate approximately potential output trend and observe fluctuations in actual output. Represented research of Parliamentary Budget office depends on widely accepted univariate statistical method Hodrick-Prescott (HP) filter and Christiano-Fitzgerald’s (CF) Band Pass (BP) filter. Based on HP filter, output gap was decreasing during 2013 but improved at the end of 2013 (IV quarter of 2013). After that output gap continues to decrease and reach the negative meaning. Herewith, in IV quarter of 2014 the actual output increases that improves the output gap (see chart 2,4). Based on Christiano-Fitzgerald’s BP filter actual output is lower than its potential level at the beginning of 2014, but start to improve from II quarter of 2014 (see chart 5).
It is worth to mention that potential output is not directly observed and aforementioned statistical methods represents general trend of the output gap. Measuring output gap for Georgia is based on small time series data that can increase errors in represented results. Moreover, univariate statistical methods use only real GDP for measuring potential output and omit others economic variables that can influence the level of potential GDP. Therefore, it is interesting to compare results received from univariate statistical methods with the results received from complex macroeconomic model. With this direction further research will be provided for the interested groups by Parliamentary Budget Office. (Read complete document in Georgian)