An output gap measure for the euro area: Exploiting country-level and cross-sectional data heterogeneity

Abstract

This paper proposes a methodology to estimate the euro-area output gap by taking advantage of two types of data heterogeneity. On the one hand, the method uses information on real GDP, inflation, and the unemployment rate for each member state; on the other hand, it jointly considers this information for all the euro-area countries to extract an area-wide output gap measure. The setup is an unobserved components model that theorizes common output trend and cyclical components across euro-area economies in addition to country-specific counterparts. I estimate the model with Bayesian methods using data for the 19 countries of the euro area from 2000:Q1 through 2018:Q3 and perform model comparisons across different specifications of the output trend. The estimation of the model preferred by the data indicates that, because of negative shocks to trend output during the Global Financial Crisis, output was only slightly below potential in that period, but an output gap of about negative 3% emerged during the European debt crisis. At the end of the sample period, output is estimated to be 3.5% above potential output, which is growing at an average annual pace of only 0.5% in recent years.