Most people are very familiar with the concept of GDP growth as the main gauge of the level of activity in an economy and the fluctuation of the business cycle. However, a much more crucial, and yet far less well-known, indicator of the business cycle is the so called “output gap”, which essentially measures the “temperature” of the economy, defined as the difference between demand and supply. In the short term, economic activity is defined by the level of (domestic and foreign) demand, as supply is relatively inflexible. In the long run, though, the ability of the economy to grow and produce wealth is dependent upon its production base and its supply capacity. The fluctuation of demand around the long-term supply trend is the main business cycle creating mechanism. A positive output gap indicates an overheating economy where demand is running above supply. This creates inflationary pressures and external imbalances calling for restrictive monetary and fiscal policies. Conversely, a negative output gap signals excess supply, which calls for expansionary policies in order to mitigate the degree and duration of economic contraction.
From the above, one can easily conclude that a timely and accurate estimation of the output gap is of paramount importance for every economy. However, judging the level of demand and, especially, supply is notoriously difficult especially for economies that are in the process of restructuring and transition such as the economies in the SEE region.
Despite these difficulties, in this current issue of our Quarterly Review, we make a first attempt to estimate the output gap for Bulgaria, Romania, Serbia and Ukraine. We estimate the output gap for these countries using not the traditional “Cobb-Douglas production function” methodology, but a more practical approach that is based on the level of unemployment and capacity utilization. Somewhat unsurprisingly, we find that the output gap in these economies had narrowed substantially in the years before the 2009 recession, but it has returned to negative values – indicating underutilized production capacity – in the years after the crisis.