Sweden: The output gap conundrum

Fri, Nov 3 2006, 16:28 GMT
by Roger Josefsson


  • The output gap is a measure of resource utilisation in an economy and is used as an indicator of inflationary pressures. In equilibrium, when the output gap is closed, inflation should be at the target, 2 %.

  • If you have thoroughly studied the publications from the institutions (MoF, NIER, Riksbank), you might have noticed that they at times divide the output gap (resource utilisation) in two; a labour market gap and a productivity gap.

  • Over the last few years a dichotomy has appeared. The labour market gap has been negative, whereas the productivity gap has been strongly positive, and the resulting output gap often closed (or very near being closed). But at the same time, inflation has been very much below target.

  • The estimates of the output gap has - inter alia - lead the Riksbank to (erroneously) foresee rather swiftly rising inflation, and the NIER to “abandon” the output gap for the labour market gap as an indicator for inflation.

  • But why do estimates of the output gap suddenly seem to fail, despite working quite nicely over several decades (at least when evaluated ex post)?

  • Before loosing ourselves in theory (and wild speculations), what impact does this rather theoretical discussion have on financial markets? - Well, in short, if we can find a correct explanation to what we have chosen to label the “output gap conundrum”, than we will have a pretty good chance of identifying when the Riksbank goes wrong.