Potential Output and Foreign Trade in Small Open Economies

In open economies excess demand in the tradables sector often manfests itself in an external deficit instead of the employment gap that is applied in the usual Phillips-curve model. The inflationary pressure in this case arises from an expected or actual weakening of the exchange rate and its pass-through into prices. This phenomenon gave the idea to define an output as sustainable ('potential') if it does not rely on a permanent increase of external indebtedness. Both domestic and foreign demand shocks generate deviations of actual aoutput from the potential. Potential output for Hungary, Mexico, and Poland was estimated using the Kalman-filter.