Output gap assessment through Danmarks Nationalbank's production function framework

The output gap is a key guide for economic policymaking and analysis. It is often used to quantify inflationary pressures and thus plays a central role in Danmarks Nationalbank's assessment of the state of the Danish economy. This paper refines Danmarks Nationalbank's existing production function framework - which decomposes total production into labour, capital and a Solow residual - presented in Andersen and Rasmussen (2011) and Danielsen, Jørgensen and Jensen (2017) in several ways. First, we implement Bayesian estimation techniques rather than the frequentist maximum-likelihood estimation used previously. Second, we enhance each of the component sub-models for potential labour force participation, unemployment and the Solow residual. As a robustness check, we separate foreign labour from domestic labour inputs in our production function, allowing for a more nuanced analysis of labour-market dynamics, and conclude that our estimate of the output gap is robust towards that nuance. According to the model estimates, potential output - defined as the level of output the economy would achieve if prices and wages had fully adjusted to current economic conditions - has picked up in recent years. This increase is driven both by a larger labour force and a higher Solow residual, which captures, for example, total factor productivity and merchanting and processing activities by Danish companies.