Output Gap and Inflation nexus: A case study of New Zealand

Submitted by:
Haseeb Ullah Khan
Submitted to:
Dr Tanver-ul-Islam

1 Introduction:
It is generally consensus that price stability is very crucial to the economic
well-being of the nation because it is very helpful to increase the efficiency of
monetary system and reduce the uncertainty about the future in a country.
Thats why Price stability is one of the fundamental objective of monetary
policy in both developed as well as developing countries. To achieve this
goal, monetary authorities use different types of tools like pegging currency,
further adjustments through government switching deposits and open
market operations. Despite all of these measures inflation can be increased
due to depreciation of currency, investment by government to build
infrastructure and other economic activities in the country. So it is very
important for monetary authorities to understand the relationship between
economic activity in the country and inflation. Output gap is a key
component for understanding of this relationship because it is very helpful in
assessing inflationary pressures and the cyclical position of the economy.
Output gap is generally defined as the deviations of actual output from its
potential levelpotential level is the maximum amount of goods and
services which can an economy produce at its full capacity. This output gap
could be either Positive or Negative. Positive output gap reflects an excess
demand and this excess demand leads toward high rates of inflation. While
negative output gap shows that there is excess capacity to produce more
than actual rate and exert a downward pressure on inflation.

There are different macroeconomic policies to address positive and negative

output gaps. When this gap is positive, central bank will adopt that monetary
policies which restrict aggregate demand to maintain inflation but in case of
negative output gap central bank will use expansionary monetary policies
that are helpful to stimulate aggregate demand. Hence, we can say that
output gap is a significant indicator to understand and predict the future
values of inflation. A standard approach which is used to measure
relationship between inflation and output gap in literature is the Ordinary
Phillips Curve.
1.1 Objective of study
The objective of the study is to find the relationship between inflation and
output gap in New Zealand and also found that how economic activities
affects the decisions of monetary authorities in New Zealand.
2 Data and Methodology:
To find the relationship between inflation and output gap, I select New
Zealand and use the time series data from 1977 to 2014 on Consumer price

index (2010 = 100) and GDP (constant LCU) from World Development
Indicator (WDI). Let Pt is the log of CPI, Yt denotes the log of output in the
selected countrys economy and Yt* is the log of a measure of potential
output for the economy. First we estimate output gap and then find the
relationship between output gap and inflation.
To evaluate the relationship between inflation and output gap in New
Zealand we use different alternative models which are extensively use in
literature.
1) Model 1 is Standard linear Phillips Curve
pt =+ pt 1+ ( y t y t ) + t
2) Model 2 relates the changes in inflation to the changes in output gap
(Claus 2000)

3) Taylor rule and loss function

i= r* + pi + 0.5 (pi-pi*) + 0.5 (y-y*)

2.1 Methodology for estimation of potential output and output Gap

There are different methodologies available in the literature to find output
gap. Broadly these methodologies can be grouped into three main
categories: statistical methods, structural methods and mixed methods.
Statistical methods include the linear trend, the quadratic trend, the H-P
filter, etc and does not rely on economic theory. Structural methods are

theory based and it requires one to first estimate the potential levels of
inputs in order to arrive at the potential level of output using the neoclassical
production function. The third method is a combination of the first two
methods.
In this paper we use statistical approach and apply linear trend method to
find potential output (reason for using this linear trend method is given in
Appendix). In linear trend method we assume that output is approximated as
a simple deterministic function of time. In simple words we can say that this
approach decompose output into a trend component and a cyclical
component.
Y* = + t
Where
Y* = the potential output
= constant
t = trend
This method is very popular because it is easy to construct and interpret the
results.
After finding potential output it is easy to estimate the output gap because
we know that by definition output gap is the difference between actual
output and potential output. Hence, by subtracting potential output (Y*) from
actual output (Y) we will get output gap.
output gap=Y (actual)Y( potential)

2.2 Methodologies for estimation of relationship between output

gap and inflation
Output gap is generally used as an indicator of inflationary pressures in the
economy thats why we are interested in quantifying the extent to which the
different output gap measures can provide reliable forecasts of inflation in
the New Zealand. This involves the estimation of different equations of
inflation that includes the output gap as an explanatory variable.
Model 1 (Mohammad Osman and Rosmy Jean Louis 2008)
we use model 1 which is a standard linear Phillips Curve specification that
relates current inflation to past inflation and to current and past output gaps.
pt = + pt 1+ ( y t y t ) + t
Where
pt = inflation
pt-1 = lag of inflation
Yt-Yt*= output gap
t = IID regression error term
From the equation of linear Philips curve it is clear that inflation depends
upon its lag values and output gap.
Model 2 (Mohammad Osman and Rosmy Jean Louis 2008)
We can use model 2 as a rival model to standard Philips curve which show
the relationship between changes in inflation to the changes in output gap
(Claus 2000).

= Inflation

GaPt-k= lags of output gap

The above equation clearly shows that current inflation depends upon
change in current output gap.
Model 3 (Gert Peersman and Frank Smets 1999)
3rd model is based on Taylor rule and we consider a loss function also
i= r* + pi + 0.5 (pi-pi*) + 0.5 (y-y*)
Where:
i = nominal fed funds rate
r* = real federal funds rate
pi = rate of inflation
p* = target inflation rate
Y = logarithm of real output
y* = logarithm of potential output
Loss function is given below

This model suggests that central should care about the volatility in annual
inflation from a constant inflation target, short term interest rates and
variation in out gaps.

3 Empirical results of standard Philips curve:

We find the empirical results of model 1 by applying OLS methodology and
results fulfill the requirements of standard linear Philips curve and shows a
positive relationship between output gap and inflation.

GAP represents the output gap in model and Dpt-1 shows the 1st lag of
inflation in model and results of both variables are significant at 5% level of
significance and 10% level of significance respectively. Coefficient of Dpt-1
tells that 1% change in lag value of inflation increase current inflation by
0.75% and coefficient of output gap tells that 1% increase in output gap
leads toward almost 0.15% increase in inflation.
3.2 Predictive ability of different models

To compare the predictive capability of the different models, benchmarks are

used in literature. The two important benchmarks are autoregressive (AR)

and test forecast (TF) benchmark.

4 Conclusion:
The primary objective of this paper is to estimate the relationship between output
gap and inflation in New Zealand. There are different methodologies available in
literature to find this relationship and each method have some advantages and
disadvantages. Our results of linear standard Philips curve shows that there is a
positive relationship between output gap and inflation rate. Our results of study
suggest that the output gap is a factor which increase the inflationary pressure in
the country. Hence central bank should keep close eye on this factor during policy
making to control the inflation in country.
5 References:
Claus, I. (2000), Is the Output Gap a Useful Indicator of Inflation, Reserve Bank of
New Zealand, Discussion Paper Series No 2000/05.
De Brouwer, G. 1998, Estimating Output Gaps, Reserve Bank of Australia
Research Discussion Paper No, 9809.
Gerlach, S. and F. Smets (1997), Output Gaps and Inflation, Bank for International
Settlements mimeo.
Gibbs, D. 1995, Potential Output: Concepts and Measurements, Labour Market
Bulletin of New Zealand Department of Labour 1, pp. 72-115.

Slevin, G. (2001), Potential Output and the Output Gap in Ireland, Central Bank of
Ireland Technical Paper, 5/RT/01
Watson, M.W. (1986), Univariate Detrending Methods with Stochastic Trends,
Journal of Monetary Economics, 18(1), pp. 49-75.
Watson, M.W. (1986), Univariate Detrending Methods with Stochastic Trends,
Journal of Monetary Economics, 18(1), pp. 49-75.
Watson, M.W. (1986), Univariate Detrending Methods with Stochastic Trends,
Journal of Monetary Economics, 18(1), pp. 49-75.

Appendix

Results of lags of output gap and inflation