Investigating potential output using the Hodrick-Prescott filter: an application for Malta

Modern economics assumes that in the long run an economy develops in a balanced way, with full employment of resources and a constant inflation rate. The output level thereby achieved is called „potential output‟. Knowing the extent of the output gap, or the deviation from this equilibrium, is crucial both to guide discretionary policy and to help set an environment conducive to higher long-term growth. Consequently substantial research has been carried out to devise methods to determine the equilibrium output of an economy. This paper, after reviewing the most used method from the two main branches of empirical investigation, namely the Hodrick-Prescott (HP) filter and the production function, argues that they both suffer from significant failings when applied to very small and open economies like Malta. The latter tend to have series that exhibit a number of pronounced trends, large fluctuations and recurrent structural breaks. Lack of data seriously constrains the production function approach in such a setting. However, non-structural methods like the HP filter tend to exhibit very pronounced changes in the output gap that are out of line with the theoretical idea of equilibrium, with results also affected significantly by shocks to data. In turn, these reflect the small size of the economy rather than actual changes in potential output. Two suggestions are put forward. The first one involves an innovative application of the standard filter, whereby the upper and lower bounds of a series are defined and equilibrium is determined as a weighted average of the HP filter applied separately on these bounds. This can result in a smoother output gap series with the possibility of long-term deviations from equilibrium. The second suggestion involves an integration of structural features into the standard HP filter. The modified or generalised HP filter would allow researchers to set limits on the impact exerted by structural or temporary shocks and to allow for the possibility of having lengthy periods of ...