A Practitioner’s Guide to Potential Output and the Output Gap

This paper provides a comprehensive literature review of potential output and output gap estimates from the perspective of a fiscal authority and, by extension, an independent fiscal institution tasked with assessing cyclically adjusted fiscal indicators. Considering the mandate of these institutions, the focus is often broader in the sense that more sources of imbalances and longer horizons are considered. Yet it is similar to other institutions in terms of the methods used to assess the unobserved potential output and the output gap. The paper reviews univariate and multivariate trend-cycle decomposition methods that are actually used within the Network of European Union’s independent fiscal institutions. It summarizes their salient features and provides a critical review of commonly used methods. This literature review preludes the back-testing exercise assessing the quality of output gap estimates and the discussion of their real-time applied issues in the context of cyclically adjusted fiscal indicators.