Inflation and Real Disequilibria

This paper outlines some problems with the methods often used to construct measures of real 'disequilibria' or 'gaps' (eg the output gap) and to examine their relationship with inflation. It then offers a structural vector autoregression alternative which is used to construct estimates of output, unemployment and capacity utilisation gaps. Gap estimates are constructed by summing the effects of particular structural shocks, where the shocks are identified using long-run restrictions derived from theory. The approach has four main advantages over other methods. First, it uses economics rather than statistics to construct the gaps. Second, the estimates are not contingent upon particular assumptions about the structure of the economy. Third, it does not impose a rigid causal chain running from gaps to inflation. Fourth, it permits the simultaneous construction of several gap measures and the examination of their relationship with inflation in a single framework, so that the three gap measures are internally consistent and can be used to make inferences about the structure of the economy