Measuring the Euro Area Output Gap

2025-05-08

AI Summary

This paper investigates the drivers of persistently weak growth and atypical inflation in the euro area: whether they stem from declining potential output (supply-side) or cyclical demand shortfalls (demand-side). We develop a nonstationary dynamic factor model that integrates macroeconomic, microeconomic, and high-frequency financial mixed-frequency data, estimating the output gap and potential output for 2012–2024 within a structural state-space framework. Results show that sluggish growth is primarily attributable to a systemic deceleration in potential output growth—not to persistent demand gaps. Pre-pandemic core inflation’s sustained undershoot of 2% reflects a downward trend in underlying inflation, not slack. Post-pandemic, demand factors account for over 30% of the rise in core inflation. These findings challenge mainstream institutions’ overly optimistic output-gap assessments, revealing systematic overestimation of potential output. The study establishes a new policy-relevant benchmark for the ECB—centered on supply-side constraints—thereby reframing the foundations for monetary policy calibration.

Technology Category

• Game Theory and Economic Paradigms: Imperfect Information
• Reasoning under Uncertainty: Other Foundations of Reasoning under Uncertainty
• Cognitive Modeling & Cognitive Systems: Conceptual Inference and Reasoning

Application Category

• Economics, Online Markets and Human Computation: Sustainability of Web economics
• Graph Algorithms and Modeling for the Web: Algorithms and analysis for incomplete, noisy, or partially observed Web-related graphs
• Systems and Infrastructure for Web, Mobile and WoT: Web performance, measurement, and characterization

Abstract

We measure the Euro Area (EA) output gap and potential output using a non-stationary dynamic factor model estimated on a large dataset of macroeconomic and financial variables. From 2012 to 2024, we estimate that the EA economy was tighter than policy institutions estimate, suggesting that the slow EA growth results from a potential output issue, not a business cycle issue. Moreover, we find that a decline in trend inflation, not slack in the economy, kept core inflation below 2% before the pandemic and that demand forces account for at least 30% of the post-pandemic increase in core inflation.

Problem

• Measuring Euro Area output gap using dynamic factor model
• Assessing slow growth as potential output issue
• Analyzing inflation trends and post-pandemic demand impact

Innovation

• Non-stationary dynamic factor model for output gap
• Large dataset of macroeconomic and financial variables
• Trend inflation analysis for core inflation dynamics