5/RT/01 - Potential Output and the Output Gap in Ireland

for helpful comments on earlier drafts. All remaining errors and omissions are the author's. Comments and criticisms are welcome. ABSTRACT This paper estimates potential output using a number of statistical trend methods and a Cobb Douglas production function. Two measures of the output gap using the Cobb Douglas production function method are estimated. One measure models technology as a linear time trend while the other method allows technology to vary over time. The relationship between the output gap and inflation is examined and the results suggest that the output gap alone is insufficient to explain inflation in the Irish economy. The Cobb Douglas production function output gap which models technology as a linear time trend is the only measure that has a significant relationship with inflation. A measure of " domestically generated " inflation (defined as the gap between the services inflation rate and the goods inflation rate) is used to capture domestic inflationary pressures arising from the Irish labour market. The results imply a stronger relationship between the output gap and " domestically generated " inflation. Estimates of the potential output growth rate of the economy are discussed and preliminary forecasts of the growth of potential output are outlined.