A study of potential output and output gap in the Czech Republic

Abstract

Analysis of economic cycle is of enormous importance for monitoring economic output and explaining price and wage inflation. It provides essential information for shaping economic and monetary policy of central authorities. Several methods are currently available to estimate potential output and output gap. In the current study, methods of Hodrick-Prescott filter and Cobb-Douglas production function were implemented to estimate potential output, which cannot be empirically observed. For the purpose of comparing the above methods, quarterly and annual time series of real GDP, labour and gross fixed capital starting in 1996 were used for estimation of the output gap. Relative contributions of labour, fixed capital formation and technology improvement factor towards growth of potential output were quantified for the studied series. The Cobb-Douglas production function appears to be superior to Hodrick-Prescott filter in providing quality estimates of potential output. Hodrick-Prescott filter allows estimation of potential output; nevertheless, it fails to identify components of cyclic behaviour of economic activity. Cobb-Douglas production function describes level of potential product assuming average utilization of production factors. A detailed analysis of components of economic growth in the observed period is provided.