International Finance Discussion Papers

What is the output gap? There are many definitions in the economics literature, all of which have a long history. I discuss three alternatives: the deviation of output from its long-run stochastic trend (i.e., the “Beveridge-Nelson cycle”); the deviation of output from the level consistent with current technologies and normal utilization of capital and labor input (i.e., the “production-function approach”); and the deviation of output from “flexible-price” output (i.e., its “natural rate”). Estimates of each concept are presented from a dynamic-stochastic-general-equilibrium (DSGE) model of the U.S. economy used at the Federal Reserve Board. Four points are emphasized: The DSGE model’s estimate of the Beveridge-Nelson gap is very similar to gaps from policy institutions, but the DSGE model’s estimate of potential growth has a higher variance and substantially different covariance with GDP growth; the natural rate concept depends strongly on model assumptions and is not designed to guide nominal interest rate movements in “Taylor” rules in the same way as the other measures; the natural rate and production function trends converge to the Beveridge-Nelson trend; and the DSGE model’s estimate of the Beveridge-Nelson gap is as closely related to unemployment fluctuations as those from policy institutions and has more predictive ability for inflation.